Monday, January 4, 2010

The Eighth Wonder of the World: Compounded Interest

Baron Rothchild once said "I've never seen all the seven wonders of the modern world but, I know what the Eighth Wonder of the Modern World is: Compounded Interest". Many of us have come across this term 'Compounded Interest' in financial periodicals, the newspapers or even in the world wide web. However, some of us might find the explanation vague as it is normally explained in tandem with an investment strategy/plan. It is a rudimentary concept, yes. However, it is an essential concept that one should understand before delving into the world of investing. I'm sure that many of us are led to believe that compounded interest is better than fixed interest and yes, it is true! An investment that promises compounded interest is a better investment than investments that promises fixed interest. Now, if you still have that nagging feeling about finding out why compounded interest is always good news, read on!

Fixed interest based upon principal means that interest is given based on the initial capital invested. To make things clearer, if a fund promises a fixed interest rate of 5% per annum and an investor invested say $1,000.00. After a year, his investment will grow to = $1,000.00 + ($1,000.00 X 5%) = $1,050.00. In simplicity, it simply means that the investment will only pay 5% of interest based on the initial investment amount which is $1,000.00 in this context.

Conversely, in a compounded interest scenario, during the the first year the growth will be same as the growth in a fixed interest fund. However, it is only after the subsequent years where the fun really starts! This is because interest is calculated on the current value of the fund (the total of initial investment sum and the interest earned in the previous years. Okay, this may look mind boggling so to make things clearer, lets assume the same amount was invested ($1,000.00) with a compounded interest of 5%:-

First Year
$1,000.00 + ($1,000.00 X 5%) = $1,050.00

Second Year
$1,050.00 + ($1,050.00 X 5%) = $1,102.50

Third Year
$1,102.50 + ($1,102.50 X 5%) = $1,157.63

See how the interest is calculated by totalling the initial investment amount with the interest earned in the previous period? Investments with compounded interest give returns based on the current value of your investment. Or in other words, interest upon interest! Now, lets compare between the two different interest policies:-

First Year
$1,000.00 + ($1,000.00 X 5%) = $1,050.00 <- Compounded Interest
$1,000.00 + ($1,000.00 X 5%) = $1,050.00 <- Fixed Interest

Second Year
$1,050.00 + ($1,050.00 X 5%) = $1,102.50 <- Compounded Interest
$1,050.00 + ($1,000.00 X 5%) = $1,100.00 <- Fixed Interest

Third Year
$1,102.50 + ($1,102.50 X 5%) = $1,157.63 <- Compounded Interest
$1,100.00 + ($1,000.00 X 5%) = $1,150.00 <- Fixed Interest

See the difference between both the investments? The investment that promised a compounded interest had given the investor $7.63 more. So now you finally know what compounded interest is really about, give those investments a check to see what kind of interest are they promising. Still find it difficult to understand? Drop me a comment and I will see what I can do to help.

Shaun Ng, Signing Off. =)

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