In school we were taught simple interest as being Principal, Rate multiplied by Time divided by 100. Compound Interest on the other hand has a formular of P(1+r)^n. But what does this all mean and how does it affect our everyday finances.
Take the case of Wale, James and Buchi who have been friends since they were toddlers just like their parents too. They turned 30 recently and looked forward to finally gaining access to a bank account set up by their parents on their 16th birthdays. Their parents each deposited a sum of N1million in their bank accounts, a move they all collectively agreed was befitting of their lovely kids. However, each parent pursued different means of investing the money agreeing not to withdraw a single kobo from the funds for the next 14 years.
Wale had access to his account and found a sum of N1.4million. His parents had deposited the money in a bank account that earned a simple interest of 10% per annum for 14 years. Wale had an extra N400,000 after 14years.
James discovered he had a total of N3.79million in his account having earned an extra N2.79m over the course of 14 years. James’s parents preferred to invest his birthday gift in a fund that return an interest rate of 10% per annum. However, they left an instruction to the bank to re-ivest the interest at the same rate.
Buchi finally had access to his bank balances and realized he had about N27.8million in his account!!! He had earned a whopping N26.8million extra on his N1m. His parents had invested his money in a fund that earned 2% per month with an instruction to reinvest the interest at the same rate for the 14year period.
Above is a pure demonstration of the power Compound Interest has over simple interest. Albert Einstein, the great scientist once said “Compound Interest was the most powerful force in the Universe”.?Compound interest arises when interest is added to Principal, such that the interest ?that has been added also earned interest.?This is unlike Simple Interest where interest is not added to principal.
The major difference in the financial fortunes of the three friends is the usage of compound interest. Whilst Wale’s parents invested in Simple Interest, James and Buchi’s parents leveraged on the power of Compound Interest. Even at that, the way and manner compound interest is used also matters.
James’s savings was invested with an interest compounded annually. Meaning, every N10 he makes as interest for a savings of N100 is re-invested at the same rate of 10%. So at the beginning of the year he invests N100 and gets N10 as interest at the end of the year. In the second year he invest N110 (N100+N10) at 10% and gets N11 as interest. This is added to the N110 (N110+n11) and invested and so on.
Buchi on the other hand made N2 every month for every N100 he invested. The N102 (N2 + N100) is then re-invested the next month at 2% earning N2.04. N104.4 (N102+2.04) is then re-invested again and so on.
It is important to note that there is an element of risk to every investment that you make. The higher the expected returns as in the case of Buchi, the higher the risk that the money may be lost. Conversely, as in the case of Wale, low returns on investment are typically associated with lower risk.