Power of Compound Interest on Savings

compound interest formula

Whether you liked Mathematics or not, you may have learned compound interest and simple interest calculations in secondary school. However, chances are your teacher never told you the practical importance of compound interest formula in life. This article explained the benefits with some examples of compound interest.

It is important to know the power it has on your savings efforts. Quite frankly, compound interest can be life changing for someone saving money. Don’t believe me?  Let’s ask a wise man – Albert Einstein. He said :

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it. 

One secret of getting rich slowly is the miracle of compound interest. Even a small percentage returns can increase your bank balance given enough time and commitment; mainly time.

What is a Compound Interest?

Compound interest is the interest calculated on the principal amount and the accumulated interest of previous periods of a deposit or loan. Compound interest can also be term as “an interest calculated on interest,”.

Compound interest can be your friend or otherwise. Put it in different way, you deposit money in a bank and they pay interest on the deposit and accrued interest. If you borrow money, they charge interest on the outstanding loan and unpaid interest. If this happens consistently over a long time horizon and interest rate, the results can be phenomenal.

If compared to compound interest, simple interest calculates interest on the initial deposit or investment amount only.

The Power of Compound Interest

If you are interested in planning for better financial situation, it is extremely important to start saving as soon as possible.  Even if it is just D200 a month, starting early can have an enormous impact on your personal financial position.  I often meet with people who mention that they will wait until they earn better salary or less dependents to start saving. Well, life is about unlimited demand against few resources.  It is not wise to wait till you feel comfortable enough to start saving.

Parkinson’s Law says, no matter how much money people earn, they tend to spend the entire amount and a little bit more besides.  Their expenses rise in lockstep with their incomes.

 Ten reason you should start saving now

Savings should be treated as if it were a monthly bill you owed to the banks. If you don’t pay, the banks would come and charge you with penalty rates.

Compound interest on D10,000 one-time deposit

Let assume that you have deposited D10,000 in a bank account and it pays 10% annually. What will be your bank balance at end of year 3? The balance should be D13,310.

How? Let’s have a detail look at the calculations:

Year 1 – 10,000*10% = 1,000 and new balance should be D11,000

Year 2 – 11,000*10% = 1,100 and new balance should be D12,100

Year 3 – 12,100*10% = 1,210 and new balance should be D13,310

At end of first year, interest was calculated on the initial deposit only, however year 2 used initial deposit plus interest earned in year 1 and year 3 used initial deposit plus interest earned in year 1 and 2. This process is what financial gurus called compounding.

Still continuing with the above example, what do you think will be in your bank account with one-time deposit of D10,000 for 20-years? Over D67,000

Compound interest really can be the best friend to a disciplined saver or investor.  I cannot stress enough how important it is to start young and save often.

Compound interest on annual D5,000 contributions

Compounding can be made even more powerful through regular savings and investments. It looked great that a single D10,000 in savings account can grow to more than D67,252 in 20 years, but it is even more exciting and powerful to see what can happen when you make a regular savings.

If you were to save D10,000 per year for 20 years, and the money earns 10 percent interest, what will be savings account balance at end of 20th year? Your balance will stand more than D630,000.00 (I have the free excel template).

You do not need to guess that there are thousands of people who have worked for more than 20 years and have ability to save D2,000 per month but still have stressful financial conditions. They failed to create wealth and spends every credit to their name.

This is the extraordinary power of compound interest formula.

How compounding periods impact investment and investment returns?

Compounding periods refer to the frequency with which interest is applied to your investment. Interest may be compounded daily, weekly, monthly, semi-annually, or annually. A key relationship exists between time and interest rate. The shorter the compounding period, the higher the effective annual interest rate (the actual rate you are earning on your investment after taking the effect of compounding into account). For example, if interest is compounded daily, the investment will grow faster than if the interest is compounded monthly or annually.

You want to down an excel copy of compounding interest formula, then visit our free template page.

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17 Comments

  1. Good work EB on simplying these for some of us. Interest rates on Savings accounts and T-bills in The Gambia exponentially exceed the rates on Savings and CDs in the USA. Some of us resort to investing in the very volatile stock market. My concern is the rate of inflation in The Gambia and the potential impact if I decide to put large amounts of savings inDalasis. Could you provide us some insight on that?

    • You are very right Sainey. According to Central bank, the consumer price inflation was 7.1% in Mar 2016. Normal savings are paying between 5-7% interest, which means the real interest rate will be negative for those who put money in the normal bank savings account.
      Nonetheless, one could also consider treasury bill investment which returns about 20% yield on the 1 year bills. This means the real interest will be about 12.9%. There are 3 key risk assessment an investor would consider in this situation:

    • Depreciation of dalasi against foreign currency. Dalasi depreciation will not be very important if you are not considering to return the funds back to USD.
    • Risk of increase in inflation during the investment
    • Credit risk of the bill issuer (central government).
  2. thanks, it is another important lesson for me to learn. Now I understand the deference between simple and compound interest.

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