Compound interest is the rocket booster that will help you reach your savings goals faster. Put simply, compound interest means you not only receive interest on the money you invest but interest on your interest as well.
For this to occur, you need to reinvest all interest payments on your investment. Over time, this simple concept becomes a powerful wealth creation tool. Before we get to the power of compounding, let’s look at the difference between simple and compound interest.
Simple vs compound interest
Term deposits pay what is called simple interest. Say you invest $10,000 in a 10-year term deposit at 5 per cent. Each year you will earn $500 in simple interest; after 10 years your investment will grow to $15,000 ($10,000 principal plus $5,000 interest).
Now let’s look at what happens if you invest your $10,000 in a savings account at 5 per cent a year and reinvest all interest payments for 10 years. After 10 years your initial investment will grow to $16,470 ($10,000 principal and $6,470 interest). This is because each year the interest is added to your account and you earn interest on your interest, or compound interest.
Of course, the actual outcome will depend on factors such as the interest rate and the timing and frequency of interest payments. Some institutions compound interest on cash investments monthly, others quarterly, half-yearly or annually. Some charge fees, others don’t. Look for the effective interest rate (sometimes called the effective yield or annual percentage rate APR) which takes all this into account.
Einstein is also credited with saying that he who understands compound interest earns it, while he who doesn’t pays it. If you’ve ever racked up debt on a high interest credit card you will know what he’s talking about. In the first month you fail to repay your debt in full you pay simple interest, but after that you pay interest on your interest.
When patience pays dividends
The magic of compounding can also be applied to other investments, such as shares. If you reinvest all dividend payments in additional shares you effectively increase future potential capital growth and income.
This is a smart way to grow wealth during your working years, but it takes some discipline to reinvest your twice-yearly dividend payments. Some companies offer dividend reinvestment plans which removes the temptation to take the money and spend it.
Whilst superannuation gets a bad wrap, the combination of enforced saving and time with the application of compound interest by reinvesting income makes a pretty fantastic way to create wealth.
When you or your employer make contributions to your super fund they are locked away, along with all investment earnings, to compound until you retire or reach a condition of release.
Someone entering the workforce today could have 40 years or more to grow a retirement nest egg. Even for those on a modest salary, time and patience will allow compound interest to turn it into something worth waiting for.
With discipline you can actually apply this approach to other investment vehicles too. Investing as little as $100p/m can have an outstanding effect over time!
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