Harnessing the power of compound interest

Albert Einstein allegedly called compound interest the 8^th wonder of the world. In the realm of personal finance, few concepts wield as much transformative potential as compound interest. Compound interest can help turn modest investments into substantial wealth over time. At its core, compound interest is the concept of earning interest not only on the initial investment but also on the accumulated interest from previous periods. This compounding effect can lead to exponential growth.

Let’s use an illustration. You start your investment journey with a sum of US$10,000. Along this journey, you will add US$3,000 each year, and observe the terminal value of our investment at different interest rates: 5%, 8%, and 10%. At first glance, the differences between these interest rates may seem negligible, but over time, the disparities become strikingly evident. The graph below demonstrates this phenomenon. 

5% Interest Rate: Starting with a conservative 5% interest rate, our $10,000 investment, coupled with annual contributions of $3,000, begins its journey. After just one year, our investment grows to $13,150, thanks to compound interest. Fast forward ten years, and our account blossoms to approximately $48,485. But the true magic happens over the long term. After 30 years, our investment balloons to a staggering $310,785. That's more than 31 times our initial investment! Compound interest rewards patience and consistency.

8% Interest Rate: Now, let's examine the impact of a slightly higher interest rate of 8%, with annual contributions of $3,000. In this scenario, the growth rate is faster due to the higher rate of return. After 30 years, the investment would have grown to approximately $474,219.41, more than $200,000 higher than the 5% interest rate scenario. This demonstrates the significant difference that even a small increase in interest rate can make over the long term.

10% Interest Rate: Lastly, let's explore the impact of a 10% interest rate, with annual contributions of $3,000. At this rate, our investment experiences even more rapid growth. After a decade, our account swells to an impressive $100,000. Thirty years later, our investment matures into an astounding $1,293,087. The power of compound interest at a 10% rate is truly awe-inspiring. It showcases how even a relatively modest annual contribution can lead to extraordinary wealth accumulation over time when coupled with a high interest rate. For context, the 30-year average annual return of the S&P500 Index is roughly 9.7% per annum.

Consistency is the most important part of this journey. Regardless of the interest rate, one common denominator remains—the steadfast commitment to making regular contributions. It's this consistency that fuels the compounding engine, allowing our investments to flourish exponentially.

Marian Ross-Ammar is Vice President, Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm

Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm