The magic of compound interest when saving money

The concept of compound interest can be applied to many different areas of your life but we'll look at how it can multiply your savings greatly in this post. 💸

What is compound interest?

Imagine compound interest as a snowball ⛄️.

You’ve got some money in the bank that’s currently the size of a golf ball. Over time, this ball rolls down a snowy hill, and gathers more and more snow (interest). Soon this ball keeps growing and becomes the size of a beach ball. The longer it rolls down the hill, the larger the snowball gets. 🏔

So how does it work?

Imagine you have RM100 in your savings account and you're earning 3% interest on it.

In Year 1, you'll earn RM3 from the interest. That means you now have a total of RM103 in your account. So what happens in Year 2?

You'll earn 3% on RM103, not on RM100. That’s where the compounding or snowball starts, and overtime this grows into a big wealth ball. ⚽ Now, let's look at some examples.

Time is on your side

We have two savers, Emira and Jason.

Emira started saving RM5,000 every year at the age of 18. She stops when she turns 28. Over a period 10 years, she's saved a total of RM50,000. Additionally, she's also been earning a 10% interest from her savings annually. And so at the age of 58, she has accumulated RM1,529,542.01.

Jason has also been saving, but he started at the age of 28. Unlike Emira, he saves RM5,000 until he retires at 58 years old. This means Jason has been saving for 30 years, with a total of RM150,000. He also enjoys an interest rate of 10%, but at the age of 58 his total amount is RM904,717.12.

Although Jason saved up 3 times as much as Emira, Emira still has more. She only saved for 10 years, when Jason saved for 30 years. The reason? The snowball effect. The effect is so drastic that Jason cannot catch up, even if he saved for those 20 years extra.

How much should I save?

This depends on:

1. Where and how you'll save your money

If you put your money in a Fixed Deposit, then you're guaranteed a certain return, which will be more accurate. You can also invest your money in the stock market for instance, but there might be not as much guarantee.

No matter what stage in life you’re at, it’s never too late to enjoy the benefits of compound interest. You may identify more with Jason than Emira, but Jason is still doing better than the person who has saved nothing.

2. Your retirement savings plan

Check out your EPF savings and Private Retirement Scheme (PRS). How much have you saved already? What interest rate are you getting on your investments?

How much you allocate to your retirement is entirely subjective and personal. It depends on how you comfortably you want your retirement to be. But it's recommend to set aside least 33% of your income every month for your retirement.

If you’re in the private sector, you’ll already be contributing 11% + 12% employer’s contribution to your EPF. This means you only need to save another 10% to reach that monthly 33%. The pay yourself method might be enough for your retirement.

Get started now

As we've shown, the earlier you start saving and get started earning interest on them, the better.

Use an online compound interest calculator (Moneychimp has a good one) and start playing around with the numbers. See how much money you’d need to contribute to get to your financial goal.

Maybe you'll find that early retirement or buying a house is sooner than you think. 😉