Compound interest - what it is and how you can gain from it

 

Ever wondered how saving can earn so much interest over the long term? It's thanks to the beauty of compound interest. Here's what it is, and how it works.

Compounding is the central pillar of investing - it's the reason investing works over the long term. Compound interest refers to “the process of generating earnings on an asset's reinvested earnings”. More simply, this means that over time, you are earning returns on money you have previously reinvested - that is, earning interest on your interest!

A great reason to reinvest your returns

Reinvesting your returns is powerful because it can make a huge difference to how much your investment grows. For example, if you save R10 000 at a return of 6% and withdraw your interest every year, at the end of 10 years, you'll still have R10 000.

But if, instead of withdrawing your interest, you reinvest the returns, by year two you're generating returns on R10 600. By year three you're generating returns on R11 236, and so on. You end up earning more interest each year because the amount invested each year is increasing, without you having to make any additional investments.

When it comes to investing, time is everything. This is why we urge you to start saving when you are in your 20s or 30s. With time on your side, your investment has so much more potential to grow.

Time - an investor's best friend

Saving for as many years as possible can have a very positive effect because of compound interest. This is illustrated by the story of Xoliswa, a university graduate who is starting out her career.

From age 25, she saves R1 000 a month in a unit trust. It's a fair amount of money, but she is very disciplined. Over time, the unit trust she's invested in generates an average return of 8% per year. By age 35, her investment will be worth R181 283. The amount she's saved every month totals R120 000 but the rest of that growth - R61 283 - is all due to compound interest. At this point, Xoliswa decides to stop her monthly contributions. Leaving compounding to work its magic means her investment will have grown to R1.24 million by age 60. Remember, this is with no additional contributions.

If Xoliswa started to save later, starting at age 35 she would have earned R326 673 less at age 60. Those 10 years make a remarkable difference, and illustrate the benefit of starting to save - and putting compound interest to work - from as early as possible.

If you haven't started saving yet, don't panic. You still have time ahead of you - the important thing is just to start - and then leave compound interest to do its magic.

When it comes to investing, time is everything.

This article is meant only as information and should not be taken as financial advice. For tailored financial advice, please contact your financial adviser.

Discovery Life Investment Services Pty (Ltd): Registration number 2007/005969/07, branded as Discovery Invest, is an authorised financial services provider. Product rules, terms and conditions apply.

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