Personal Finance: Compounding Interest

A lot of Filipinos are familiar with the term interest rates. We have encountered it in our savings account, loans or investment. Although most Filipinos are familiar with the word interest rate, there are those who do not fully comprehend the compounding effects of interest rates. Depending on how compounding interest  affects your finances, it can either increase your wealth or empty your bank account. Most people don't realize the effects of compounding interest until they experience the effect of it in their lives. You can either let your money work for you or become a slave of money. 

interest rate

Compounding interest according to Investopedia "Interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan." In its simplest term it is "Interest on Interest". One important aspect you should carefully examine before entering into something which involves interest rates is the period which it covers. Some interest rates are on a yearly or per annum(P.A.) basis and some are based on a monthly basis. 

Lets say you have Php 100,000 and you have three investment vehicles to choose from. Product B guarantees Php 15,000 a year for your Php100,000 if you invest it for at least 15 years. Product B guarantees Php 20,000 a year for your Php100,000 if you invest it for at least 20 years. Product C guarantees 10% per annum. Which do you think will offer you a better return?

If you look at the chart and table above, both products A and B started out with better returns than Product C. The only disadvantage of Products A and B is these products both have a fixed annual returns. While both A and B have higher returns at the start of the investment, Product C started with a small annual return. Even though Product C started with lower returns, the interest earned from the previous year will also earn interest on top of the original investment. Hence the returns for Product C grows each year, eventually over taking the returns of Product A 9 years after. Product C will also surpass the total return of Product B 15 years after.

Compounding Interest is one of the investment tools that is rarely taken advantage. Harnessing the power of compounding interest is one of the tools in achieving your financial goals. Understanding how compounding interest works will help you make better decisions in handling your debts or loans.