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Compound interest: the most powerful force in the universe

Albert Einstein, one of the modern world’s greatest scientists, called compound interest the eighth wonder of the world.

“He who understands it, earns it. He who doesn’t, pays it,” Einstein declared.

So what is it about compound interest that makes it so powerful?

By its most straightforward definition, compound interest is the interest you earn on your principal investment, combined with the interest you earn on the accumulating interest.

Essentially, it’s the interest you earn on the interest you earn.

Compound interest on your cash investments

It’s most easily understood through examples.

Imagine you invest $10,000 for five years at an annual rate of 5% ‘simple interest’, which means the interest is calculated and added only at the end of the term. In this scenario, you would have $12,500 after five years, made up of your original $10,000 plus $2500 interest, calculated at $500 per year for five years.

Using this same scenario investing $10,000 at 5% for five years, but this time switching from simple to compound interest that’s calculated and added monthly, at the end of five years you will instead have $12,834.

So with all else being equal, the switch from simple to compound interest means you gain an extra $384 without doing anything else.

You can imagine how dramatic these figures become with larger principal sums invested over longer timeframes, in investments such as superannuation funds.

The two ingredients that add magic to compounding

There are two ingredients that super charge compound interest.

The first is time. As you continue to accumulate interest, your investment starts to expand exponentially.

Again using the scenario above of $10,000 at 5%, after 10 years you’d have $16,470.

After 25 years, you’d have $34,813. That is $24,813 interest on top of your initial $10,000.

You can see the exponential curve on the table below.

Source: Calculated using ASIC’s MoneySmart compound interest calculator

When you add the second magic ingredient, things start to get really exciting: and that is adding regular incremental savings to your mix of principal and accumulating interest.

Let’s say you start to add just $40 a month to your initial $10,000. After five years, you’d end up with $15,554.

After 10 years, you’d more than double your original investment and have $22,681. After 25 years, you’d end up with $58,633.

If you upped your monthly investments to $100, you’d turn $10,000 into $31,998 in 10 years and $94,364 in 25 years.

The table below shows what a huge proportion of this final sum is made up of compound interest.

Source: Calculated using ASIC’s MoneySmart compound interest calculator

There’s a great compound interest calculator at ASIC’s MoneySmart website if you’d like to play around with a few numbers yourself: Link here

Start saving now

The power of compound interest combined with small incremental savings over time is something you should tell every single young person you know, right now.

Here’s why. Let’s say Savvy starts saving $100 a week when she’s 25, while her twin brother Spender drags his feet for 10 years and doesn’t start his $100 a week savings plan until he’s 35.

If they both invest at 5% from their respective start points and until retirement on their 65th birthday, with all else being equal, Savvy will end up with $661,275 (made up of $208,000 total deposits and $453,275 interest) and Spender will end with $360,645 (on total deposits of $156,000 and compound interest of $204,605). You can see Savvy earns more than double the amount of interest by starting early.

Compound interest and your share portfolio

Compound interest is not limited to cash investments. It also works in your share portfolio through the dividend reinvestment plans (DRP). When you opt for the DRP instead of receiving the cash payout of your share dividend, your dividend is used to buy additional shares in the company – so your total number of shares rises.
From there, it’s simple: with a greater number of shares, your dividend payouts increase so you can buy a larger number of new shares each time (in theory).

When compound interest works against you

So what did Einstein mean when he hinted at the negative ramifications for those who don’t understand compound interest?

Basically, it’s the reverse side of the coin. When you borrow money and you’re paying interest, compound interest works against you in a downward spiral that gathers pace.

The most common way you’ll see this play out is at the bottom of your credit card statement where the bank explains how many decades it will take you to pay off your amount owing if you only pay the minimum amount (the regulators forced the banks to add this information so that people understood the implications of taking that minimum-only option).

Another warning you may have come across is when you borrow additional money against your mortgage, perhaps to realise your dream renovation. It might be tempting to borrow $100,000 against your mortgage rather than taking out, say, a five-year loan. But if you throw $100,000 onto the mortgage at 5% and end up taking 30 years to pay this extra amount off, then the cost of that renovation will almost double to $193,256 by the time you’ve finished paying it off.

Of course there are other factors at play that will influence your decisions about borrowing money. But as the great man said, it’s important that you at least understand it.

Take heed to the wisdom of Einstein

Later in his life, Einstein reportedly upgraded his praise of compound interest from “the eighth wonder of the world” to “the most powerful force in the universe”. Here’s guessing he reaped rewards from the exponential upward curve.

 

This information is a statement of personal opinion only and is not intended to constitute general or personal advice to any person or entity.

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