Ever heard of the phrase “make your money work for you”? That, in a nutshell, is what compound interest does. It’s your money making more money over time.
Compound interest can grow your wealth because it is interest that’s earned on top of interest already earned. This concept applies not just to the money saved in your bank account, but on returns earned on your investments too.
Compounding powers your investment returns
Investing is one of the most powerful things you can do to build wealth for the long-term. In Singapore, a high-yield savings account may give you less than 1% annual interest (after you’ve fulfilled all necessary criteria) but an investment in Singapore real estate investment trusts (REITs) could give you an average annual return of 6.9%.
Here’s an example of how compounding works to turbocharge your investments. Suppose you invest $100,000 today. 20 years later, your original investment would have more than tripled to $386,968, assuming it earns 7% every year.
Put simply, your investment grew through compound interest. By leaving your investment untouched, your portfolio gains were reinvested. Interest grew on both your principal and reinvested gains.
But if you take out the interest on your investment each year without reinvesting it, you’ll only earn $7,000 every year for a total of $140,000. Compare this to the $286,968 you could have earned if you had let compounding do its magic instead.
How to make compounding work for you
To reap the benefits of compounding, remember that time is your best friend. The earlier you start investing, the more your money will grow.
Let’s look at two friends, Jack and Jill.
Jack starts investing at age 25. He invests $20,000 every year for a total of 10 years. Thereafter, he stops contributing to his investment portfolio and leaves his money invested for the next 30 years.
Jill starts investing later than Jack. She begins at age 35 and invests $20,000 every year for 30 years.
Can you tell who will be richer in retirement?
The graph above shows why you benefit from investing as soon as possible. Jack invests for only 10 years, but ends up with more money than Jill, who started investing later. This is despite the fact that Jill’s total contribution amount is $400,000 more than Jack’s.
Give it time
You can also see that the graph above gets progressively steeper with time. This reflects how compounding builds on itself to accelerate your wealth creation.
Warren Buffett exemplifies this best. It took him roughly 56 years to build a net worth of $1 billion. But to turn $1 billion to $60 billion took only 27 years. Thanks to the power of compounding, the largest increases in his net worth took place in the later years of his investments. This is also why patience and a long-term perspective is important when investing.
Let your earnings be reinvested
It can be tempting to take your dividends out of your account and spend them every year. But reinvesting your dividends is a much smarter way to boost your compound returns.
By buying more shares using your dividends, you grow your investment base. Remember, when your investment amount is higher, your compounded returns are higher too. And over time, it can seriously add up.
According to Syfe’s calculations, reinvesting your dividends can give you an extra 0.5% in returns each year. This is also why dividends in your Syfe account are automatically reinvested for you at no extra charge.
Compounding is truly one of the ways anyone can use to build wealth. Getting the most of it is simple: invest early, be patient, and reinvest.