“If you understand compound interest, you basically understand the universe.” (Robert Breault)
Don’t be simple
One of the best ways to understand compound interest is to know what it’s not — the appropriately named simple interest. This easy example illustrates the difference between the two.
Mr X decides to invest in an account that pays simple interest of 10% on his capital. He invests R1 000 000 for three years and ends up with:
- R1 000 000 PLUS the total interest of R100 000 X 3 which is R1 300 000.
Mrs Y, on the other hand, decides to invest her capital in an account that pays compound interest of 10% for three years:
- After the first year, she earns R100 000 in interest and her capital amount increases to R1 100 000.
- After the second period she earns R110 000 in interest, and her capital amount grows to R1 210 000.
- At the end of the 3-year term, she earns R121 000 and ends up with an amount of R1 330 000.
In only three years Mrs Y earns an additional R30,000 by selecting an account that pays compound interest. But if they had both invested for ten years, the difference between the capital in the simple and compound interest accounts would be a staggering R593 742!
The underlying principle of compound interest is that you earn interest on an ever-increasing amount of capital, as opposed to only on the original capital amount.
Be sure to read the fine print
Not all compound interest is created equal, however, as the number of times the interest is paid on the growing capital makes a huge difference. If the compound interest is paid monthly, your capital growth will be greater than if it’s paid yearly.
Let’s apply this principle to the above compound interest example.
- The COMPOUND interest on the capital amount of R1 000 000 paid annually amounted to R1 593 742 at the end of the 10-year period, resulting in a total capital amount of R2 593 742 at the end of the period.
- If the interest were paid monthly, Mrs Y would end up with a capital amount of R2 707 041.
The more frequently the interest is paid, the greater the growth on growth.
The more often you contribute, the better
The number of periods is also very significant when contributing to an investment. The greater the frequency of your contributions, the greater the growth. Let’s look at an example:
- If Mrs Y starts with a capital amount of R1 000 000 and contributes R100 000 per year for ten years and earns 10% interest, she’ll end up with a capital amount of R4 346 859 after ten years.
- If she has a capital amount of R1 000 000 and contributes R8 333 monthly (R100 000/12) to the investment for ten years, she’ll end up with R4 428 239.She earns R81 380 more by contributing monthly.
The same applies to unit trusts
Unit trusts offer one of the easiest ways to reap the benefits of compound interest. By simply opting to reinvest the dividends you receive from your investment, your investment will grow exponentially.
Compound interest can be your enemy
As much as compound interest works in your favour when investing, it works very hard against you when you use debt. If you don’t pay off your credit card timeously, the amount owed is compounded monthly – meaning that new laptop could very easily end up costing you a lot more than you bargained for. A credit card balance of R20 000 which carries an interest rate of 20% (compounded monthly) will increase your debts by R4,388 in one year.
How to ensure compound interest works for you
Now that you understand how it works, it’s important to make sure compound interest is doing everything it can to improve your financial situation.
When investing in a bank account be sure to ask:
- Whether the interest paid is simple or compound interest (don’t be fooled by higher simple rates).
- How often the interest is paid (the more often, the better).
When investing in a unit trust:
- Choose to reinvest your dividends earned.
- Invest as frequently as you can.
There are many Future Value calculators online that can assist you to calculate how much compound interest you could be earning. Alternatively, ask us to crunch the numbers. Knowledge is power! Be an Einstein and take full advantage of the magic of compound interest to let your capital work hard for you.
Disclaimer: The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.