Compound interest: why time is literally money
A lot of the times we hear that the sooner we start saving, the better. This rings true, especially when it comes to compound interest. The longer you save, the better your chances are at reaping compounding rewards.
The concept of compound interest can be a bit complicated and confusing. That’s why we’ll try to simplify it for you, so you can get a better understanding of what it is and how you can benefit from it.
What is compound interest?
Compound interest is an interest that you earn on your interest. And, when you don’t use up your interests, it continues to grow and lead to what’s called exponential growth. For example, when you save, you earn interest on your savings. The higher the interest rate, the more interest you earn. Over time, you will keep earning interest on your original savings and, if you don’t withdraw the interest, you will start to collect interest on the interest you’ve just earned. This process is referred to as compounding.
With compound interest, money works for you instead of you working for it. When you invest, time allows your invested money to grow. When you let it sit for longer, it can dramatically multiply the value of your investment. What this does is, it allows you to accumulate total investment from the interest growth and less from the contributions you make on your investments.
How does compounding work?
The impact compounding will have on either an investment or a loan depends on:
- The amount invested – this is the amount of money that you intend to invest.
- The period – the period of which you wish to withdraw it.
- The growth rate – this is the rate of return on investment.
- The compounding frequency – the more frequently interest is added to the original amount, the greater the impact of compounding.
Let’s simplify this, shall we? When you deposit money to your bank account, there’s a certain interest that the bank pays on your deposit. For example, if you earn a 5% annual interest, a deposit of R10 000 would gain you R500 after a year. If you keep this money in the bank without making a withdrawal for at least another year, this is where compounding comes in. You will earn interest on your initial deposit of R10 000, and you will also earn interest on the interest that you have just earned. So, the interest you earn in the second year will be more than the year before because your account balance is now R10 500, not R10 000. Although you didn’t make any deposits, your earnings will increase.
Let’s use another example.
The below table uses an investment of R10 000 towards your retirement and annual compounding to illustrate how compounding works. After 20 years, your R10 000 investment would have grown to R67 275 – which would mean you would have gained R57 275. This interest will only be accumulated if you let the money grow on its own without making any withdrawals.
|Number of Years||Amount of your investment||Return rate||The total amount with return earned|
|Year 1||R10 000||10% annually = R1000||R11 000|
|Year 2||R11 000||10% annually = R1100||R12 100|
|Year 3||R12 100||10% annually =R 1210||R13 310|
|Year 4||R13 310||10% annually = R1331||R14 641|
|Year 5||R14 641||10% annually =R1464||R16 105|
*calculations of compound interest for the first 5 years
How do you ensure compounding works for you?
For you to benefit from compounding, you need to start saving as soon as you can. Don’t overthink it or try to convince yourself to put it off until a certain time or period in your life. No matter how much you earn, you can find a way to start saving. In addition to that, you’ll need to be disciplined and consistent to earn compound interest.
Compounding requires you to forget about your investments, and let it grow without paying much attention to it. The longer you let it grow, the more interest you accumulate. It’s a difficult thing to, especially when times get tough, however, the benefits are worth delaying the reward for.
Contributing factors to pay attention to
Compounding happens when interest is paid repeatedly. In the beginning stages of compounding, the returns are not impressive. But you start to realise the growth as the interest continues to accumulate over the years. Below are lists of things that you should focus on when compounding:
Time – we’ve established that time is an important factor when it comes to compound interest. To reiterate, you will experience exponential growth on your savings when you leave your money alone, over time.
Frequency – the frequency of compounding matters. When opening a savings account, look for one that compounds daily. What usually happens with banks is that the interest payment is added to your account monthly but the compound calculations are done daily.
Deposits – making regular deposits to your savings account works best. Make sure that you do not make any withdrawals as this would decrease the impact of compounding.
Interest rate – the interest rate is also an important factor in your account balance over time. Higher rates mean an account will grow faster.
The bottom line
As it is with anything in life, the first point of action is realising the goal. And, once you know what you are working towards, the rest will fall into place. However, not without effort from you. At first glance, compounding seems slow but the longer you leave your money untouched, the greater it can grow. Compound interest grows exponentially over time and it requires you to be disciplined and keep your eye on the prize. The earlier you start, the greater the growth. So, start today, allow your money to grow, and earn yourself a better financial future.
‘Compound interest is the eighth wonder of the world. Those who understand it, earn it… those who don’t, pay it.’
– Albert Einstein