compound interest

Understanding the miracle of compound interest on your investments

11 Jan, 2017

The saying “time is money” is often applied to labour – doing nothing is failing to make money – but have you thought about how it applies to saving money, too? When you invest your money well and let compound interest do its thing, the results over time are truly amazing.

 

Compound interest: an illustration

There is a story about an Indian Rajah which explains the idea of compounding rather well. The Rajah wanted to reward one of his courtiers, and asked him what he would like.

The courtier brought out a chess board and requested that one grain of rice be placed on the first square, two on the second, four on the third, and so on – each time doubling the amount until all 64 squares were occupied. The Rajah, wondering why the courtier had made such a humble request, happily agreed. But it wasn’t until his men set about the task that they realised – thanks to the effects of compounding – that there wouldn’t be enough rice in the whole of India to cover the final square.

The poor courtier was beheaded as a punishment for his insolence.

Fortunately for you, compounding needn’t result in you losing your head. Except perhaps figuratively, in excitement at the amount of money it can make you.

 

What is compounding?

In money terms, compounding involves saving some money and letting the earnings build up and accrue interest, instead of spending them. 

Let’s imagine two friends, Jim and Jeff. They each have $10,000 dollars to invest, and they each put their funds in an account earning interest at a rate of 10% per annum.

At the end of the first year, both friends have made $1,000 in interest. Jim wants to buy a new phone, so he withdraws that $1,000 and keeps the $10,000 capital in his account. Jeff, however, has read this article and knows all about compound interest, so he doesn’t touch that $1,000 and instead has $11,000 invested. At the end of the second year, Jim receives another $1,000 in interest. This time he wants to treat himself to a holiday. Jeff’s interest is up to $1,100 this year, and again he leaves it untouched. Jim has a balance of $10,000 whereas Jeff now has $12,100 working for him. That’s a 21% increase in capital for Jeff, and all he had to do was leave the money alone – no further investments required.

Compounding may seem a little slow to get going, but the effects over time are dramatic – especially with a greater capital investment.

If you invested $100,000 in a share trust, for example, and the investment earned 10% per annum, it would end up doubling in value every seven years if you always re-invested the earnings. The figures, rounded off, would look like this:

 

Starting investment:   $100,000

End Year 7:                  $200,000

End Year 14:                $400,000

End Year 21:                $800,000

End Year 28:                $1,600,000

End Year 35:                $3,200,000

End Year 42:                $6,400,000

 

Remember, there is no additional investment needed; this just requires you to leave the money (and earnings) untouched. The vital thing to note is that the growth for each seven-year period is always greater than the total growth in all the previous periods. From years 36 to 42 the investment grew by $3,200,000, whereas in the previous 35 years the growth was $3,100,000. From years 22 to 28 the growth was $800,000, but in the 21 years before it was $790,000.

The longer you leave it, the more you make and the faster your investment grows. If you managed the full 42-year program but your friend didn’t start as early and only managed 28 years, you would have four times as much as them in the end. And THAT is why you should start saving early (and not be tempted to spend the interest on a phone or a holiday).

 

To summarise:

  • Compounding is the effect of interest accruing on your initial investment and any subsequent earnings (interest being reinvested to earn more interest).
  • Using this method, an investment at 10% interest per annum can double in value every seven years.
  • The effects of compounding accelerate the longer the investment is left.
  • It really is worth starting to invest as early in life as possible to get the full benefits of compound interest.
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