Compounding interest is indeed the 8th wonder of the world, as this saying was made famous by Albert Einstein. Compound interest is an essential concept to understand when managing your finances. It can help you earn a higher return on your savings and investments, but it can also work against you when you’re paying interest on a loan.
How does compound interest work? How is it calculated? How can you take advantage of this simple yet phenomenal concept to maximize your investments? Let’s explore this together.
How does it work?
Compound interest is like a “snowball effect”. A snowball starts small, but as more snow is added, it gets bigger. The more it grows, the faster it becomes bigger. The accumulation of interest on interest is a result of you reinvesting the interest income instead of paying out/withdrawing. The effects of compounding interest depends on
- The frequency of the interest being paid; and
- The interest rate applied.
Most of us will get a pleasant surprise when we check our EPF membership account annually and the sum is much more than we contributed i.e. ~24% monthly for our salaried friends. This defined benefit is automatically deducted from your monthly salary and if you wish to save more, you may top up RM5,000 every month via online banking into your EPF account.
Building a comfortable nest egg will take time and careful planning. If you play your cards right, by the time you hit retirement age at 55, you can have a comfortable sum so you can enjoy your golden years with the same lifestyle.
What are the best compounding interest investments available?
- Fixed income instruments – Fixed deposit (FD), bonds : Considered a safe investment, FD are issued by banks and generally offer higher interest than savings. These FD pay you interest at regular intervals. As they mature, you get both the principal and the interest. Your money is tied up in these FDs until your account reaches maturity, but if you don’t need the income right away, these are a safe investment. While you run the risk of inflation ie 2-3% in Malaysia, these investments are low risk and up to RM250k in each bank account is guaranteed by the government via Perbadanan Insurans Deposit Malaysia (PIDM).
A word of caution is to always ask your banker for the highest available FD rate or shop around to find a bank that can offer you the best rate- see imoney/Ringgit Plus. If the bank auto renews your FD upon maturity, it will be done so at the default lowest rack rate. If you’re looking for foreign currency FX, choose a bank with a foreign presence in developing countries eg: Vietnam or Cambodia. Convert your MYR into USD and place them into USD FD in either of the country and enjoy ~8% interest rate on your FD. Of course, there is a sovereign risk to consider in case anything happens to the country. Funds kept in foreign currency will not be protected by PIDM.
- Rental income – This is a great passive income earner if you receive more than 3% per annum to beat inflation and on top of that, your rental property will also give you capital appreciation. However, the downside of this investment as the property owner is that you have to manage your asset. Properties need to be maintained, and there’s no money to be had if you have a tenant from hell! If you have a reliable tenant and a well-cared-for property, rental homes can pull in excellent passive income. Though this option isn’t as liquid as some of the other options on this list especially if you have to pay down the mortgage, this asset can bring in a long-term and steady cash flow. In Malaysia, there is a property supply glut and you should run the rental numbers to ensure you can cover the:
a. Mortgage repayment
b. Provision for maintenance payment & repairs
c. Council taxes and then make 3% per annum after deducting all these costs.
If this sounds too daunting to you, please take a look at investing in REITs.
- Real estate investment trust or REITs – for those who like the idea of getting rent money but not keen on managing the property, REITs are the next best thing. REITs are a company that owns and operates real estate. This investment acts as a passive income, giving you 4-5% dividend per annum and you’ll also have capital gains/loss depending on market movement.
No matter which stream of compounding interest you choose, it is suitable for savings and will have a multiplier effect in years to come which will end up increasing your net worth.
