Do you want to know what I enjoy more than saving and investing money? Calculating money. And that’s exactly what we’re going to do today. So you might have clicked on this blog post because you, like me, are looking for ways to get some more of that cheese, mula, dough, bread and all other qualifying adjectives that describe money. Well, you’re in the right place because today, together, we are going to open our eyes to the beautiful world, that is, compound interest.
So I would just like to preface this post by saying, this is not a get rich quick scheme. If this could work within a year or two, I wouldn’t be here sitting down this hot afternoon writing about it, so keep that in mind. This takes decades to reach, so time and patience are your best friends on this journey. Also, the numbers shown here would vary depending on your location and your current financial disposition, so what I’m trying to show you in this post is the underlying concepts and techniques.
Now that that is out of the way, what is compound interest?
Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.
Now, I don’t know about you but that definition doesn’t really say much to me. I won’t see that definition and become excited to start putting my hard earned money in that kind of investment strategy, so let me simplify it a bit.
Essentially, what compound interest is, is the act of reinvesting the interest gained after a period of time, rather than taking it out and spending it. So it is the opposite of what you would do with simple interest. In the case of simple interest, you put your money in the bank or an investment object and earn an interest on that amount, maybe 5% — 8%, and then you remove that interest and go do something with it, but in compound interest, rather than removing the interest, you put it back for another investment period and make a profit on that interest. That’s basically what it is.
So let me show you what I mean with real numbers. Grab a book, a pen and a calculator.
So the general formula for compound interest is….
A = P(1+(r/n))^nt
A is the final amount
P is the initial amount that was invested
R is the interest rate
n is the amount of times the interest is compounded, so for a yearly compound interest, the value is one, but for let’s say a monthly compound interest, it would be 12.
t is the time period of the investment.
To illustrate this concept, I would be using an amount of #100,000 as a start. So there are two ways of looking at this technique.
- You put a fixed amount of money and then you leave it to increase over time or
- You invest an amount of money each year without removing any amount or interest.
Let’s start with the first one, which would really give you an idea of how mind-blowing this concept is.
Let’s say you decided to invest #100,000, with an interest rate of 10% yearly for 10 years.
Using the compound interest formula, your P (principal) is #100,000, R (interest rate) is 10% and t (time) is 10 years.
So in just ten years, you’d be able to double your money without having to do any work. Now some of you might be saying to yourself, “ten years is a long time to wait to make just 250k. Aren’t there other faster ways to double your money in a shorter time?”
And to that I’ll say, probably, but the risk involved in those kinds of businesses is usually too high and most likely a scam. We are looking long-term.
Now, like I said, this amount is supposed to be peculiar to you, so some of you can save wayyy more than 100k a year and some others might be lower.
Let’s look at the average time for retirement, if you’re 20 years old now, and you invest 100k, in 50 years you’ll have close to 12million naira in savings, with just saving 100k today. That’s astronomical, and when you find other investment opportunities that can give you more than 10% interest rates, we’re talking big numbers here. And what I’m saying in this point is a one-off investment, 100k once this year and never save again, now what if you save and invest 100k every year.
If we consider how we should be saving, which is a set amount monthly or yearly, this gives a more accurate depiction of the power of compound interest. The first method was just to give you a general idea of how compounding works, so I hope you don’t just save once and then never save again. That’s not a cool idea at all.
So, starting with the same 100,000 naira again at 20 years old at 10% interest. But this time you save and invest 100,000 naira over and over again each year without removing the previous investments and interest.
First year, you save 100k, at 20% interest, you make 110k at the end of the year.
Then the following year, you don’t remove the 110k, but add an extra 100k to it.
This means that you are now saving 210k, at the end of the second year, you now have 231k in savings from just saving 200k, because remember, you have only put in 200k of your own money, 100k in the first year and 100k in the second. That’s about a 15% increase.
Now let’s zoom out and look at a 50 year period before retirement.
Saving 100k a year, for 50 years at 10% interest rate would leave you with 128million naira at 70 years old. And you’ve only saved 5million of your own money. That’s a 2460% profit increase in your money. I don’t know about you but that’s really impressive.
So we can see how compounding impacts your financial situation. But the key thing here is time. Time is what is going to make the difference between how fast you actually reach your financial goals. You just have to start early, like right now, and the problem is that a lot of people don’t have the patience to wait that long to make profit. You can’t be short-sighted and I hope this illustration has given you a clearer vision of what is possible. Everyone wants the next get rich quick scheme to double your money in 5 months. But if you’re looking for long term wealth, compounding is the trick. I remember them teaching us this in secondary school, but for some reason, it didn’t look like a real thing. Maybe it’s the way they taught it, but it seemed like some abstract thing so I never paid any attention to it, until a few years back that I got reintroduced to it in a better light, and in just 5 years of trying compounding, I’ve already seen massive advantages in my portfolio. Time goes by faster than you think, so don’t wait.
And compounding doesn’t only apply to money, the same technique can be applied to habit formation, productivity or any aspect of human life. Little improvements consistently, can make for mega growth after a while. There’s a reason why Albert Einstein says
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
Lastly, give a lot.
There is joy in giving to others. There’s no point in accumulating wealth for yourself if you can’t share it with the world. And on a final note, after everything I’ve said in this post, why would you choose to bet on sure odds, when you can bet on something that is actually sure and concrete and also not lose all your money in the process?