The Magic of Compounding Interest

What is so special about the power of the power of compounding interest that the famous scientist Albert Einstein called it the 8th wonder of the world? 

He went on to state that those who understand it earn it and those who don't will pay for it. 

It is, therefore, essential to understand what interest is, how compounding interest fits in your life, and how to use it to improve your life. 

The magic of compounding interest is a financial concept that illustrates the power of time and consistency when it comes to saving and investing money and how your investment can magically grow even when you do nothing.

Compounding interest allows your money to grow not only on the initial principal but also on the interest that accrues over time. 

In other words, as long as you do not withdraw your principal and dividend, you will earn interest on your interest, which can significantly boost your wealth over time.

However, it is essential to note that the magic will only work if you do not withdraw the money invested, as the main contributor to the power of compounding is the interest received and reinvested.

If you keep withdrawing the interest earned, your money will never grow; in fact, it will keep decreasing in value because of inflation.

How Does Compounding Work?

You need to focus on these 4 areas, which are:

1. Initial Investment: You start with a certain amount of money, which is your principal
2. Interest Accrual: Over time, your investment will receive interest, depending on the terms and conditions of the financial product. With compounding, the interest earned is added to the principal, and future interest calculations are based on the new balance, which is principal plus interest.
3. Reinvestment: The interest you did not withdraw and leave in the account. If you keep it long enough, it will continue to earn more interest in subsequent periods.
4. Time: The longer you stay invested, the more time your money can grow. Compound interest becomes particularly powerful over longer time horizons as long as you reinvest your dividend and do not withdraw your principal.

The main factors that will ensure the magic of compounding interest will grow your investment are:

1. Frequency of Compounding: The more frequently the interest is compounded, the faster your money grows. For example, daily compounding will grow your money faster than annual compounding.

2. Interest Rate: The higher the interest rate, the faster your principal will grow because you earn more interest on your principal.

3. Time Horizon: The longer you keep the money, the more significant the effect. This is often referred to as the "time value of money.

To illustrate the power of compounding interest, consider this example:

Suppose you invest RM1,000 at an annual interest rate of 5%. After one year, you'll have RM1,050. In the second year, you'll earn 5% on RM1,050, not just from your original RM1,000. So, in the second year, you'll have RM1,102.50. Over time, the growth becomes exponential, and your money can potentially double, triple, or grow even more.

What if you start investing with just RM100 every month? How much will the accumulated amount be after 5 years if the average dividend is 5 percent yearly? The accumulated amount is around RM6,629, of which RM629 is the accumulated dividend.

To grow your investment, you need discipline and commitment to do it for a long time. Without discipline and commitment, you may not be able to save even a thousand ringgit, let alone build an emergency fund.

It would help if you did not forget that investment will help you to prepare yourself for unfortunate events and, at the same time, achieve financial freedom. 

In fact, investing and building a fund is more effortless than imagined, especially with low-risk investment options such as Amanah Saham Bumiputera (ASB) and Fixed Deposits in which you will not lose investment capital.

To start investing with high commitment and discipline, you can set an automatic monthly investment. Even if the amount is as low as RM10, you need to start somewhere to have the chance to taste the magic of compounding interest.

The key takeaway in understanding the power of compounding is that the longer you leave your money to compound, the more significant the impact on your wealth and financial well-being. 

This principle is fundamental in helping you to start investing for retirement, building wealth through investments, and achieving financial goals. 

Starting early and being consistent in your investments is the best way to harness the magic of compounding interest to secure your financial future.