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Using Power of Compounding Interest to Grow Your Wealth

Updated on May 21, 2014
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Albert Einstein once described compounding interest as one of the seven wonders on earth. It is indeed a real wonder when you come to realize how fast the power of compounding interest can boost your wealth. Compounding means reinvesting all your returns on investment.

Interesting question for my intellectual readers; “Do you invest to retire on your assets or invest to earn and use your returns on investment right now?”

If you chose the latter, then magic of compounding interest won’t work for you. If you chose the first one, then compounding your returns on investment will give you more money and more options to either diversity your investment or raise your investment portfolio on investments that bring you greater returns on investment.

This hub will show you how to harness the magical powers of compounding interest and use it to your uttermost advantage.

Before you continue, I want you to watch this powerful video by a self made millionaire and best selling author Robert Kiyosaki.

Investment tips from a self made millionaire Robert Kiyosaki

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Guaranteed and Non-Guaranteed Investments

Investments can be generally categorized into guaranteed and non-guaranteed investments. Guaranteed investments involve those fixed interest investments such as treasury bills. None guaranteed investments are those investments, interests rates of which are affected by market forces. The interest rates rise, remain flat or fall as determined by market forces.

Non-guaranteed Investment and compounding interest

I am still going to use the GrowWealth Investment club as real life example. Let’s say after our investment research team proposed to the club executive that we should invest in a mutual fund, and the Partnership agreed in our monthly meeting that we should invest $10, 000 for 3 years. For the first year, interest rate rises to 5%. We are excited. Then in the second year, the interest dips by 1 %. We hold on and in the third year, it rises to 7%. With the imaginary figures given, in three years, this is what our invested $10, 000 will look like;

Club invests $10, 000

End of FY2014 - $10, 500

End of FY2015 – $10, 395

End of FY2016 -$11, 122

Let’s assume that we did our due diligence and invested on this mutual fund based on value and for medium and long term. That means the rise and fall in interest rate will affect us as much as we believe that times averages out the up and downs of the interest rate. This are just some basic tips from the investment club that you may find useful.

Guaranteed Investment and compounding interest

I will use real time examples to illustrate the power of compounding interest in Guaranteed Investment. Let’s say, GrowWealth Investment club, of which I am the club president, decides to invest $10, 000 for three years at an interest rate of 3.4%. That means every year; our club will earn a fixed 3.4% return on investment. Every year, we will reinvest the 3.4% again. That is compounding the interest. In three years, this is what our invested $10, 000 will look like;

Club invests $10, 000

End of FY2014 - $10, 340

End of FY2015 – $10, 691

End of FY2016 -$11, 055

In three years, we will end up having $11, 055 in our investment account.

You must know that because fixed interest investment assets have low risk, their returns are also low. That is something you must know in order to decide whether you invest in guaranteed investments for low returns or take calculated risks on non-guaranteed investments for higher returns.

How do you measure effects of compounding interest?

“Have you ever heard of a rule called The Rule of 72?” The rule has been around for a while but the earliest reference to the rule is the Summa de Arithmetica (Venice, 1494-1514). Luca Pacioli, an Italian mathematician, Franciscan friar, who collaborated with Leornado da Vinci, and a seminal contributor to the field of accounting as we know today is referenced as the person who coined the rule. The rule is widely use in the finance world these days.

The Rule of 72 is the fastest way to estimate how long it will take to double your money using compounding interest. The rule is not exact but works just fine as long as the interest rate is below 20%.

Let’s take another real life example:

Say the club invests $10, 000 at an interest rate of 3 % per year. All we have to do is divide 72 by 3 to give us 24. What this means is that it will take the club 24 years to double our investment of $10, 000 to $20, 000. That is if we keep reinvesting all our returns back for up to 24 years.

Saving investors look for better interest rates so that they can quickly double their money.

Negative compounding interest

Like everything else, there are risks involve in growing your money. Therefore educate yourself before you invest your money. Ignorant to this advice can cause you to lose so much money in very short time. I am telling you this because if you aren’t careful, you can lose as much money as you can just the same was as you earn. The power of compounding interest will certainly double your losses of you aren’t careful.

Say the club invested $10,000 in Bank South Pacific (BSP). In the first year, BSP stock price drops and we lose $1000. Second year the price drops again and we lose another $1000. You see! We have just doubled our loss. This is a very generalize example I am giving to give you fair idea on how easily someone can double his or her loss when negative power of compounding interest kicks in.

Conclusion

Power of compounding interest is a real wonder, a magical power to boost your wealth if you know and use it to your advantage. Hope this hub shed some light into the complex topic of compounding interest. If you found the hub useful, kindly comment and share here or with your friends in your social sites.

© 2014 Ian D Hetri

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    • Ian Dabasori Hetr profile image
      Author

      Ian D Hetri 3 years ago from Papua New Guinea

      Tom,

      Thats right. I too never learnt until i left college. I use it lot these days to give me a fair idea on on my ROI.

      Happy hubbing...

    • Tom Schumacher profile image

      Tom Schumacher 3 years ago from Huntington Beach, CA

      Agreed, Rule 72 is an easy to understand formula that demonstrates how compounding interest works. Unfortunately too many young people are unaware of this rule or the impact (positive or negative) of compounding interest. I for one never learned about Rule 72 or compounding interest until I was in college.