Albert Einstein once wrote: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
It was true then, and it’s true now. The very concept of compound interest leaves many people feeling either cold or confused, but in reality, it’s a simple process that everyone who cares about their financial future should understand.
The magic of Compound Interest is that once you get started, the benefits will be a reward that keeps on giving. In this article, we take a look at what it is, how it works, and how you can get started making the most of your hard earned money.
What is Compounding?
Compounding is a process which means that you not only get interest on the money that you originally save or invested, but you also get interest on your interest. This may not seem significant on the face of it, but we will look at a couple of examples in this article, that will demonstrate its true magic. Whenever we allow interest on our bank accounts or dividends on our share investments to be reinvested, we are opening ourselves up to the magic of compounding.
How it actually Works
When you decide to put money into an account which compounds investment returns (like your savings account or superannuation), your money goes through a process that keeps repeating and building. It works by adding one lot of interest to the initial amount and then paying interest on that new figure. As long as you leave the money and don’t make withdrawals, it will accumulate year after year.
If you start with $100 and after a year you earn $5 interest, you will then earn 5% on the $105 giving you $110.25. And at the next interest period you get 5% on the $110.25 and so on, year after year. If you think that may not work out to much, check out the example below to see the real power of compounding
An example of how the Magic of Compound Interest works
Let’s imagine that you’re 20 years-old. You have just won $5,000 from a competition you entered. Now you could use this money to treat yourself to a holiday, or to make a down payment on a car. However, if you instead decided to make that money work for you, here’s what will happen.
If you put the $5,000 in to a compounding account, which say returned 8%pa, and if you didn’t touch the initial investment and reinvested the 8%pa returns every year your $5000 would magically turn into $160,000 by the time you reached retirement age (assumed to be 65 years). Is this not the easiest $155,000 you will make in your lifetime! How many months or years would you need to work to earn that amount (let alone even save that amount)?
What is interesting about the magic of compounding is that the longer you allow your investment or savings to compound, the greater the magic.
Lets say you waited another 5 or 10 years before investing the $5000. What would the $5000 be worth when retired at 65 years?
Invest $5000 at age 20 years : $160,000 at age 65 years
Invest $5000 at age 25 years : $108,000 at age 65 years
Invest $5000 at age 30 years : $74,000 at age 65 years.
Make’s you wish you started investing as a teenager doesn’t it?
The key takeaway however is to understand that the sooner you start to save or invest (even relatively small amounts of money) can make a huge difference on the amount of money you will have in retirement.
If you don’t have a $5000 windfall to get started, then simply start by setting a target to save a small amount of money each week or month. Put that money in your savings account (or managed fund, share portfolio, etc) and let compounding start to work its magic.
You may also think that even achieving a 5% rate of return is difficult. It is if you are just focussed on putting the money in a savings account, but there are other options like investing in the sharemarket, managed funds, or ETF’s that historically have returned more than 5%pa. And as long as you reinvest your dividends, then you are allowing the magic of compound interest to work.
Disclaimer : This information is for educational purposes only and does not constitute financial or taxation advice. As this information is not advice and has been prepared without taking into account your objectives, financial situation or needs you should, before acting on this information, consider its appropriateness for your circumstances. Independent advice should be obtained from an Australian financial services licensee before making investment decisions, and a registered (tax) financial advisor/accountant in relation to taxation decisions. To the extent permitted by law, we exclude all liability for any loss or damage arising in any way.