In 1999, Warren Buffett – who was then worth US$30 billion – was asked how to make that amount of money. He said compound interest is an investor’s best friend: “I started building this little snowball at the top of a very long hill. The trick to having a very long hill is either starting very young or living to be very old.”
If you’re a budding investor, well it’s time to get to know your “best friend.” This article will explain compound interest and how it applies to almost every facet of your financial life. From your credit card debt to your fixed deposit rates, your best friend is there!
Why did Buffett reference a snowball? Compound interest is interest earned from the original principal plus accumulated interest. Not only are you earning interest on your beginning deposit, you’re earning interest on the interest. A snowball starts small, but as it rolls downhill it collects more snow and gets bigger. As it grows, it speeds up. So as your investments (or debt!) grow, they get bigger at a faster rate. Simply put, if you’re an investor setting money aside, compound interest can make you. Conversely, if you’re a debtor owing a certain amount of interest on your loans, compound interest – if not managed well – may just break you.
The Rule of 72
There is an easy rule of thumb to estimate how many years you’ll need to double your invested money at a certain interest rate: the Rule of 72. Essentially, you divide 72 by the number of years you plan to double your initial investment to find out the interest rate required to hit your target.
For example, if you want to double your initial investment of US$1,000 in 10 years, you will need to invest in a product that offers an annual interest rate of 7.2%. Here’s a handy calculator you can use. While doubling US$1,000 into US$2,000 in 10 years seems slow, this does not take into account if you top up your initial principal with additional investments periodically over the 10-year period.
To double down on the snowball on the long hill analogy, if you start investing while young, you have a long hill and thus can start investing small. Whether you are in your 20s or 30s, the principal amount doesn’t matter as much as getting off the starting blocks as soon as possible. The key is to start early, deposit frequently, and withdraw as little as possible.
Even if you invest small amounts annually over the long-term, if you start earlier, you will earn more than a similar investor starting later but putting in more money. Here’s how compound interest works over time: