Understanding Compound Interest

We encounter compound interest in many aspects of our finances, like in savings accounts, investments, and loans. And understanding how it works is crucial because it can significantly impact our financial decisions.

By discussing the concept behind it, we can better see its importance and benefits. Because when used wisely, compound interest can really be a great tool to achieve our goals in life.

So in this article, we’ll cover some key ideas that will help you better understand what compound interest really is and how it works in different situations.

Now, let’s start by explaining it in simple terms.

What is Compound Interest?

Compound interest is basically a way for us to earn money on the principal amount we have and the interest that we earn. And it can be repeated several times.

For example, if you initially have PHP 100,000 and you earn an interest of 10% per year, after 1 year, your money will be equivalent to PHP 100,000 plus the 10% interest which is PHP 10,000. The total of your money is now equal to PHP 110,000.

PHP 100,000 + (PHP 100,000 x 10%) = PHP 100,000 + PHP 10,000 = PHP 110,000

In year 2, if your interest rate is still at 10%, then you’re gonna make 10% of the PHP 110,000, which is PHP 11,000.

PHP 110,000 + (PHP 110,000 x 10%) = PHP 110,000 + PHP 11,000 = PHP 121,000

So this shows that you’re earning interest on both your principal amount and the interest you got from the year before, making a total of PHP 121,000. The process will repeat for how long your money is invested.

It accelerates the growth of your money because you’re making money from what you’ve earned on top of the principal amount. It’s making your money work hard for you.

Since we’ve defined what compound interest is, let’s discuss how it’s affected by different factors that we should take note of.

The Factors Affecting Compound Interest

There are 3 main factors that affect compound interest. And to understand it better, we’ll give examples for each.

For easier illustration, we’ll use an investment example that is compounded annually. Meaning, the interest is earned per year.

With that, let’s start with the most obvious one, which is the principal amount.

1. Principal Amount
Of course, the bigger this is, the bigger interest it’ll yield. Compound interest is a very powerful tool in wealth building because it can help you grow your money exponentially.

So to see the difference on how the principal amount affects your returns, let’s use our earlier example and say that you want to earn PHP 1 million passively.

If you start with PHP 100,000 with a 10% interest yearly, it will take you 25 years to earn PHP 1 million. (If you’re wondering how to compute this, you can use an online compound interest calculator¹.)

Meanwhile, if you start with PHP 1,000,000 with the same annual interest rate of 10%, it will only take you 8 years. That’s a difference of 17 years

The larger your money is, the faster it’ll grow over time.

2. Interest Rate
Same with the principal amount, the bigger interest rate there is, the better returns you’ll get.

For example, starting with PHP 100,000 and growing it at 10% yearly for the next 10 years, you’ll get PHP 260,000. But if you have a 15% interest rate, the same PHP 100,000 can grow to PHP 400,000 in the span of 10 years. The difference in the interest rates resulted in a PHP 140,000 difference.

In addition, you can also reach your goals faster with a bigger interest rate. As mentioned earlier, it’ll take 25 years to grow PHP 100,000 to a million at 10% rate. But at a 15% rate, your PHP 100,000 can grow to a million in 17 years. This saves you around 8 years to reach the same number.

That’s why the interest rate is important. It definitely has a huge impact on how early you can reach your goals or how much you’ll get by the time frame you have.

3. Time
The time factor is very crucial because if you're able to compound in a longer period of time, you're able to grow your money larger.

There's a snowball effect when your interest compounds over longer periods of time because you're not only earning money from your principal, but you're also earning money from the interest that you earn, so it adds up very fast.

To illustrate this, let’s say you have PHP 1,000,000 invested at a 10% rate. In 5 years, this will grow to PHP 1,600,000. But in 10 years, it’ll become PHP 2,600,000, and in 15 years, it’s almost PHP 4,200,000.

It's just like when you’re creating a snowball. When you first start, it's a small amount, it's just a small ball. But as you keep on rolling it in snow, it becomes bigger and bigger.

So to reach your financial goals faster, starting as early as possible will surely help.

Now that we’ve covered this, let’s talk about how compound interest works on various aspects of our finances.

How Compound Interest Works

Our examples above show how we can benefit from the power of compound interest. In general, it can help us with our needs as we can grow our money passively. And it can help us with our goals, like saving up for an education fund or for retirement.

But keep in mind that compound interest can be applied to debts as well. Let’s discuss this further.

A. Compound Interest in Debts
The impact of compound interest in debts works the same way like investments, but this time, it’s the other way around. Instead of making more money, you can get deeper and deeper in debts if you’re not clearing it off as soon as possible.

Using our example earlier, if you have a debt of PHP 100,000 at a 10% annual interest rate, the amount you’ll have to pay after year 1 will be PHP 110,000. And if you still haven’t paid anything by year 2, your debt will grow to PHP 121,000. This will continue to compound and will get larger if you don’t pay it immediately.

This is why it’s very important to have a plan on clearing your debts. And one effective way to do this is to use a debt snowball plan wherein you prioritize paying off the smallest debts first.

You prioritize the payment based on the amount instead of the interest charge. This creates a feeling of improvement and progress for you or the person paying the debts, and encourages to clear more debts faster.

If you want to know more about how you can get out of debts faster, you can read this previous article that I wrote.

With that, let’s now talk about how compound interest works in investments.

B. Compound Interest in Investments
Compound interest has a huge impact on growing your investment pot. Typically, the amount of money grows exponentially as you invest for a longer duration, especially if you are running at a high positive rate of return or interest rate.

Using the same figures, compounding PHP 100,000 at a 10% interest rate per year will result in PHP 260,000 after 10 years. Compared to a simple interest wherein only the principal amount will earn interest, the PHP 100,000 will just result in PHP 200,000 after 10 years.

Again, compound interest will make your money work hard for you. And the principal amount, interest rate, and time duration affect the amount of money you’ll earn. However, keep in mind that inflation reduces the growth of your investment.

We didn’t include this earlier to make things simpler. But if you're growing at the 10% rate and inflation is at 5%, your net rate of return is actually just 5% because the value of money, which is what we call the purchasing power, is reduced year after year due to inflation.

For easier understanding, let’s use PHP 100 as an example. If it grows at a 10% rate, it’ll become PHP 110. And let’s say you’re buying something priced at PHP 100. Due to the 5% inflation, the seller raised the price to PHP 105.

This means that the value of your money only grew at around 5% instead of 10%. Generally speaking, inflation eats up on the returns of your investments.

Having understood this, here’s how you can maximize your returns and leverage compounding interest in an effective way:

Choose investments wisely and start early. Be consistent in your contributions. Then when you make money, reinvest the earnings.

As your portfolio grows, diversify it across various asset classes (stocks, bonds, real estate) to mitigate risks and invest in assets that typically outpace inflation. Maintain a long-term perspective and avoid panic selling during market downturns.

And most importantly, stay invested.

P.S. If you have any investment or financial concerns or if you’re looking for an investment advisor to guide and assist you, you can schedule a call with me here.

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