28^th December, 2020 by elmads

When I was young, I always kept on hearing the word “interest”, mostly from my parents and relatives when they talk about banks and finances. I remember that I was very confused about how it works because I heard two conflicting narratives, either they receive interest from banks or pay interest to banks. Finance jargon was just overwhelming for me at that time, it gave a sense of complexity that is why I just saved money and never went to open any savings account when I was a student. As time passed by, I eventually understood what interest is, in its simplest form. The hilarious part was, I started investing first and utilized compound interest even before I had a savings account that employs simple interest.

What is an Interest?

An interest is either the cost of borrowing money (loan) or reward for saving money into banks (deposit). To further understand this definition, we must go into the basic principles of banking operations. Bank makes money by utilising money, they LEND MONEY TO people who needs financing and LOAN MONEY FROM people who wants a small amount of payment in return. The important word to remember here is “lending”.

I’ll start with deposit, when we open a savings account and place money in it, what we actually do is LEND OUR MONEY to the bank with the promise that they will pay us back in what we call as monthly deposit interest payment, depending on the initial capital we deposited in the said account. Alternately, in loan interest payment, it is the BANK WHO LENDS MONEY to the consumers. In here, the person who acquired the debt needs to pay an interest to the bank.

The interest payment is determined and given by the bank for both the savings interest payments and loan interest payments. Generally the savings interest payment is lower that the loan interest payment as this is where banks get their income from. They acquire their revenues from the difference between the spread of the deposit and loan interests. (this will be discussed further in to my BANKING SECTOR blog discussion)

Interest is of extreme importance in accumulating and growing our wealth. It is the only one true form that will make our money grow by itself. This is literally money making money for us 24 hours a day, 7 days a week, 52 weeks a year, 10 years a decade, and even forever more up until the next generation, only if we know how to handle the power of interest.

So, if we are planning to grow our money and are already on the wealth accumulation phase of our financial planning, then we need to learn by heart and soul about interest and how to maximize its two categories depending on our financial time horizon of short, medium and long-term of our objectives. If you are interested to know about the very basics of financial planning you could read my blog titled “Basic Financial Planning ‘Part 1’.

There are two types of interest, these are the simple interest and compound interest.

Simple Interest

This is what banks employ with the accounts they offer to their customers. It is calculated solely based on the principal amount. This is a very straightforward way to calculate our returns. The formula is as follows:

Principal payment x interest rate x number of years = interest

I’ll give you a clear example of this;

Let’s say that it is our first time opening a savings account in ELMADS Bank (just a sample bank name). We go to the said bank and asked for information about a specific savings account that they offer. They told us all of the information about it, including the simple interest of 1% per year. After a few minutes we then decided to take it on and open an account. Afterwards, we deposited 1,000 worth of our money to their savings account, earning a yearly interest of 1%. We decided that we will be taking out the money after 5 years. How much by then will be our earned interest after 5 years based on our initial deposit and the given deposit interest rate?

Additionally, we need to know for how long we will leave our money in a specific account, so that we will be able to compute the interest that we can earn from the day we opened the account until the day we plan to take out the money.

Majority of banks use simple interest with their savings accounts.

As we have heard from other people, placing our money in banks are not a good idea for long-term capital growth. This is because of the hard fact that banks do not give us high returns of our capital to supersede inflation. That is why simple interest is not popular for investors like us who are seeking for robust growth of our hard-earned money.

Compound Interest

This is computed on both the principal amount and the accumulated interest earned from previous periods. This is what investors like us utilize, as this is the secret sauce for our hard-earned money to work for us in the long run.

As like what Albert Einstein said, that;

Compound Interest is the 8^th wonder of the world, he who understand it, earns it. He who doesn’t, pays for it.

Albert einstein

Unlike simple interest, compound interest is complex to compute and understand. We can use both the yearly manual computation and the quick computation.

Before I show both the compounding interest computation, I just want to make myself clear about the example. We will still use the same scenario from the previous simple interest sample, but instead of placing the 1,000 principal amount in a savings account in a bank, we will be investing it in stocks of company ELM (just a sample company name) and we expect a very conservative return of 3% (take note that the worldwide average return of stocks based on the general market is around 7% based on more than 50 years of data). We will still hold this investment for 5 years.

• Yearly manual computation – The advantage of using this format is for direct monitoring of our returns of investments per year. The interest rates (same as investment returns) in terms of percentage, fluctuates especially when we invest in very volatile asset classes such as stocks and commodities. That is why some investors prefer this method, to have a better understanding of their historical performance and projections. If you have not read about the asset classes, you can read my blog titled “The 5 basic Asset Classes”. Whereas, the disadvantage of this process is the time it takes do it. As we can see below, although the computation is very simple and easy, we still need to compute the compounded returns in a yearly basis.

• Quick computation – As the name suggest, this is a fast way to obtain our compounding interest computation. As long as we have the three basic variables, which are Principal payment, Interest rate and number of year plus the formula, we will be able to compute it right away. This is less time consuming and very handy (especially when using a calculator) compared to the yearly manual computation of compound interest. The downside of this method is its formula complexity, yet once we memorize and get used to doing it, then it will eventually be just a piece of cake. In addition, this process will not be applicable for investors who want a detailed structure of their yearly investment’s compound interest performance.

Simple Interest vs Compound Interest

Now both interest methods have been explained in details, I know some of you are surely asking which one is the best then? My answer is, it depends on your time horizon objectives and goals. I’ll show you a graph that I made below, where I compared both returns together over a span of 30 years, which is a good long-term investment horizon.

The factors that need to be considered in my example graph below are the following:

–Principal Amount: 10,000 (no other deposits in between the time periods)

–Interest Rate: 5% (steady and no fluctuations)

It is clear from the numbers itself that compound interest is the undisputed winner here. That amount gained after 30 years of compounding is massive due to the fact that the interest obtained is from both the principal amount plus the earned interest of that year, which had been carried forward to the next year’s computation, unlike to its simple interest counterpart. As you can see, the 31,161.36 amount after 30 years of compound earned interest is free money, which translates to 311.61% increase from the initial 10,000 amount investment.

The yearly or monthly deposits are not yet included in this example, imagine the growth that compound interest can do when done right.

These are the goals of investors like us. Money making money for us, to the extent that it will sustain our lives in the long run even without the need for us to work for money anymore.

In conjunction, to give us another visual aid on these numbers, I maid a column bar graph below.

From the year 2020 to 2026, it is depicted from the above column graph that simple interest had been gaining more money than compound interest, but that changed in 2027. Since that year, compound interest had a monumental and exponential growth up until the year 2049 which is the end of the 30 years period.

If you want an excel template of both compound and simple interest formulas and tables, I’ll gladly send it to you. Just give me a chat on my social media accounts or send me an email.

Note: Interest rates both simple and compound can be done not just in a yearly basis but also monthly. That being said, always be attentive where we place our money, do our due diligence to research and read all of the information about the account’s policy, terms and conditions of our chosen investment instruments.

If you still find it hard to understand the two, then I’ll show you an analogy in terms of simple mathematical equations.

I guess I need-not to explain the photo above anymore. To be honest, I’m still amazed and astounded of the magic of compounding interest. Just wow!

The Dark Side of Compound Interest

Remember a part of a quote of Albert Einstein about compound interest? “HE WHO DOES NOT UNDERSTAND IT, PAYS FOR IT”. What he pertains to is DEBT! Yes, debt utilizes Compound Interest! This is what some people do, they pay for it via credit cards and loans. Imagine that 15-20% with the credit card interest rate that people pay, take note it is not compounded yearly, but monthly to daily!!!! That is why if you have debt in your name, I implore to you to pay for that first before investing. There is no one investment in this world that can sustain an investment return of 20% per MONTH, and most especially not per DAY!!

Pay off your debt first. Freedom from debt is worth more than any amount you can earn.

-Mark cuban

To sum it up

Compound interest always starts slow for a couple of year, but it eventually increases over-time, that is why investing is advantageous in the long-term haul. The benefits and capability of compounding interest is very powerful for people who are able to wait and be patient in accumulating wealth. It is also where the mentality of delayed gratification comes in with us investors.

Nonetheless it does not mean that simple interest is pointless. Remember in my blog “Basic Financial Planning, part 2”, I discussed that there are and will always be objectives and goals in the short, mid and long-term horizons of our life. Simple interest strategy is favourable for the short-term of 0-3 years, it is is usually utilised with our emergency fund, personal expenditures and other expenditures that we expect to pay within that short period of time. Now we know these two types of interest, it is up to us now on how we apply this knowledge in our lives.

Time is your friend, impulse is your enemy. Take advantage of compound interest and don’t be captivated by the siren song of the market.

-warren buffett

Knowledge is my Sword and Patience is my Shield,

Evan Louise Madriñan / elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.