How Compound Interest Works (And Why It Matters)

Setting financial goals, whether on your own or with a financial planner, is the first step in preparing for what you want to achieve in the future. Whether you want to save for your retirement, buy a home, or send your kids to university, investing as early as possible is important in setting yourself up to reach these goals. Putting the investment plan into practice, however, may feel a little daunting because it can be difficult to want to put money aside for something that seems so far away. But the sooner you start investing even a small portion each month, the easier it will be to reach your financial goals.

Suppose you want to accumulate $1,000,000 USD by age 60 by investing monthly in a portfolio returning 5% net per annum. You can either start at age 25 and save $870 USD/month for 36 years, or you can start 10 years later at age 35 and save $1,630 USD/month for 26 years. Due to how compound interest increases the value of savings over time, if you start 10 years later in this example, you would need to set aside 87% more on a monthly basis. You also would have saved a total of $133,032 USD more than if you start 10 years earlier. It pays off to start early.

Start saving as early as possible

Compound interest is calculated not on your initial deposit, but on your accumulated value. This means that you make additional money in interest on top of your investment contributions.

To illustrate, if you were to save $1,000 USD, and earn 5.0% interest, at the end of one year you would have $1,050 USD. The next year, you would earn interest, not on $1,000 USD, but on $1,050 USD; this takes your asset value to $1,102.50 USD. That means that in year one, you earn $50 USD in interest, in year two, you would earn $52.50 USD in interest, in year three, you would earn $55.12 USD in interest, and you would continue to earn more in interest each year.

Regardless of whether it’s a lump sum or monthly deposits, the power of compounding needs time to work. Because of compound interest, you can achieve your goal earlier. As the saying goes, the eighth wonder of the world is the secret magic of compound interest.

How to unlock the power of compound interest

To maximise the power of compound interest, you should not only save your money for the long-term, but also invest it. A long-term investment strategy of monthly deposits into your investment account would provide you the exposure to the returns from market activity. This investment strategy increases the amount on which your interest is calculated because it ensures that you are exposed to the market all year, to maximise chances of earning higher returns. So instead of trying to time the market, and spending time and energy guessing how the market may behave, invest long-term to increase your returns from your investments. This long-term strategy will improve the effect of compound interest due to the higher, and more reliable returns.

Effects of fees on compound interest

Compound interest works on fees too. This means that the lower investment account value due to paying higher fees has a large impact in the medium to long term. Consider this: If you invest $1,000 USD/month in two separate portfolios with pre-fee returns of 6.0% per year, and one portfolios has 1.0% annual fees, and the other has 2.0% annual fees another, the portfolio with higher fees loses $73,000 USD throughout 25 years, equivalent to 73 months of savings. This is because the fees decreased the amount that was calculated for compound interest. In short, the lower your fees, the more you have in your account, and the more you benefit from compound interest.

Design your portfolio for the long term by setting up monthly deposits into a diversified investment account with low fees so that you can benefit from the compound interest and market returns.