Tuesday, November 22, 2011

What is Compound Interest?

Many of us do not understand or we take too lightly the enormous power of compound interest. Because we lack this understanding of its value in wealth building, it is one of the reasons why most of us are impatient and not motivated to save.

Investopedia explains that compound interest is interest that accrues on the initial principal and the accumulated interest of a principal deposit, loan or debt. Compounding of interest allows a principal amount to grow at a faster rate than simple interest, which is calculated as a percentage of only the principal amount. It is defined simply as interest earned on interest.

To illustrate, let us have this example:

You have a P20,000 investment that earns 10% interest every year.
Find the compound amount and compound interest on the principal P20,000 invested at 10% annually for 10 years.

Those who are not familiar with compounding will compute it this way:

Interest for 1 year ----------- P20,000 x 10% = P2,000
Interest for 10 years --------- P2,000 x 10 years = P20,000
Total after years ------------- P20,000 + P20,000 (interest) = P40,000

P40,000 would be the correct answer if you use "simple interest" in the computation. But thanks to compound interest, your money will actually be P51,874 after 10 years. The total interest earned is more than P31,874 instead of just P20,000. This is because the interest earned each year will also earn interest in the succeeding years. 

Compound Interest + Time

The difference between P40,000 and P51,874 may not seem much. That’s only because we limited our computation to 10 years. Had we extended our calculations to 30 years, the difference would be about P269,000. For you to gain the enormous benefits of compound interest you need to give it lots of “time” to perform its job. The more time you give to make it work its magic, the bigger your
money grows. As the old saying goes “time is money” and the story of Aida, Lorna and Fe, will show you that it’s a lot of money. Read their story here, page 8.

By the way, that book Kaya mo Pinoy! 12 Steps To Build Wealth On Any Income taught me a lot about personal money management. It is written in plain English and Filipino and it offers easy to understand and easy to follow advice on how you can accomplish your financial goals and fulfill your dream of a brighter future regardless of how much you are earning now.

I am not sure if this book is available in bookstores but I purchased mine online at P345. If you are interested, just check out their website at http://www.pinoysmartsavers.com/kayamopinoy.html. There was some delay on the delivery but it was okay. I texted the number posted on their website and the author, Mr. Alvin Tabanag is quite friendly and even encouraged me to ask questions about investing.

I let a friend borrow it and I hope he'd share what he'll learn to others.

Before I forget, the table below shows how the original P20,000 principal grows each year. Notice that the interest earned every year is increasing and not fixed at P2,000. So let's start investing now! Don't procrastinate!

Year 1
P 20,000
P 2,000
P 22,000
Year 2
P 22,000
P 2,200
P 24,200
Year 3
P 24,200
P 2,420
P 26,620
Year 4
P 26,620
P 2,662
P 29,282
Year 5
P 29,282
P 2,928
P 32,210
Year 6
P 32,210
P 3,221
P 35,431
Year 7
P 35,431
P 3,543
P 38,974
Year 8
P 38,974
P 3,897
P 42,871
Year 9
P 42,871
P 4,287
Year 10
P 47,158
P 4,716
P 51,874

P 31,874

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