The power of compounding

ANTONY NGATIAAlbert Einstein (1879-1955), the great physicist of all time, called it "The greatest mathematical discovery of all time." Another quote attributed to the great genius goes: "Compound interest is the most powerful force in the universe". Warren Buffet, the greatest American billionaire, while pledging he would spend 99 per cent of his wealth in philanthropy said: "My wealth has come from a combination of living in America, some lucky genes and compound interest".After hearing such from such great people, one cannot fail to ask one pertinent question.What is compound interest which even the billionaires attribute their wealth to? Simply put, compounding is a way of calculating interest where you earn interest on interest and principal. This is as opposed to simple interest, which only earns interest from the principal amount. Since the discovery of compounding, financial institutions have been using it to varying degrees to calculate how much interest to be charged on a loan and how much interest to be paid on money deposited by customers.In our times, the need for finances is overwhelming and ways of earning it diminishing fast. But do you know that you can increase your money by compounding? Suppose 20 years ago you invested Sh10,000 in an account earning interest of 5 per cent and you never withdrew even a cent, what would you be having today?The answer has amazing results, which clearly show the miracle of compounding. Using the compound interest formula, you will find that it amounts to a whopping Sh26,533 .There is a rule called the rule of 72. According to this rule, if you want to know the number of years it will take to double your money invested in compound interest earning account, you just divide 72 by the interest rate. In the above example, it takes 14 years (14.4) to double the initial Sh10,000. Annual interestSupposing you will be retiring in December 2030, 20 years from now, and you save Sh100,000 in an account earning an annual interest of six per cent. Lets assume this money is for your retirement purposes only. If you withdraw the money after you retire 20 years from now, you will have Sh320,713.50At six per cent interest, your money doubles after 12 years. Assuming you wait for a further 12 years and withdraw the money in 2042, you will have doubled your money yet again.One lesson comes out clearly from the compounding concept. That for you to leverage on compound interest power to become financially stable, you need to invest early. Time is of essence in investing and when you have many years to wait before withdrawing your money; it will earn more. One financial philosopher said: "Time benefits the banker and betrays the borrower." Could this be the reason they compound interest on loan and credit cards daily, while they give interest on savings annually?In personal finance, one of the central concerns is whether your money is working for you or you are working for money. Compounding is your money working for you. It is not a get rich quick scheme, but a way which the rich have mastered and use to their advantagePut asideA 25-year-old graduate who gets employed today, for instance, and manages to put aside just Sh20,000 in an account earning compound interest at just five per cent annually can hope to withdraw Sh110,320 at age of 60, which is 35 years away. If he or she saves Sh2,000 every month in an account earning compound interest rate of five per cent, at 60, the amount will be Sh189,672.65.With compound interest, a little seed will grow to a prodigious size, it seems.However, financial investments, like other forms of investments suffer multifarious risks. Money loses value through inflation over time. Normally, inflation keeps on increasing, economists say. Assuming that inflation is at six per cent, it is possible to establish the time it will take for the Sh20,000 to halve in value. This is by use of the rule of 70 which financial experts use. The rule states that inflation will double the price level in 70 divide by rate of inflation years. For example, at six per cent inflation, whatever Sh20,000 can buy today will cost Sh40,000 in about 12 years or in 2032.Due to this reality, it is important that one considers saving money in an account whose rate of earning interest exceeds the inflation rate so as to have some growth. A pension fund is one good avenue where one can save their money. Although banks are considered to offer low interest rates on savings, these institutions have savings products that use compound interest. One just needs to inquire about the various offerings.There are a few tips that could be of help to a person who decides to leverage on compound interest, personal finance experts say.The first tip is for one to visualise how much they want to accumulate and for how long. Do you want to be a millionaire in say ten, 20 years? After that, calculate how much you should save using the conventional formula or the electronic calculators found online in most Personal finance websites. Alternatively, one can consult financial experts to come up with the actual monthly or yearly amount of money to save in order to hit the target.Monthly savingsThe second step is to prepare a personal budget that will enable you to prioritise and tame spending with a view to freeing up the needed monthly savings. Personal finance experts say the best way to save is to automate your savings deductions from your salary’s source in case you are employed.Third, start early and do not withdraw your money, instead watch it grow day and night. As the examples indicate, the longer you leave your money or the more regularly you save, the higher the figure grows under compound interest. Bankers know the secret just like Albert Einstein when he said, "He, who understands it, earns it ...he who doesn’t ...pays it."

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