For an investor, compound interest can be a mathematical wonder. It is the reason investing works better in the long term than just saving. We walk you through the basics of what compound interest is and why you should care.
What is compound interest? Investopedia describes compound interest as: "the process of generating earnings on an asset's reinvested earnings". In other words, compound interest lets you earn returns on previously reinvested money. You earn interest on interest.
Though it's tempting to withdraw the interest you earn, reinvesting it is what will make your investment grow. Saving
R10 000 at a return of 6% and withdrawing the interest every year means at the end of 10 years, you'll have R10 000, with R600 each year in returns (or R6 000).
If you reinvest the returns, you get returns on R10 600 by year 2; R11 236 by year 3, and so on. You earn more interest each year because the amount invested each year increases without you making any additional investments.
Compound interest may not seem that impressive on a small amount, but the larger the amount, the more substantial the effect becomes.
Time is an investor's friend
Saving for as long as possible can make a big difference thanks to compound interest. Let’s imagine two university graduates, Xoliswa and Mark, who are both starting to build their careers.
From age 25, Xoliswa saves R4 000 a month in a unit trust. It’s difficult, but she has a lot of self-discipline. Over time, the unit trust generates an average return of 8% a year. After 10 years, her investment will be worth R725 133. In total she’s put away R480 000, but the rest of that growth (R245 133) all comes from compound interest. At this point, Xoliswa decides to stop her monthly contributions. She leaves compound interest to work and when she’s 60, her investment will be R4.97 million.
The amount Xoliswa contributed in total = R480 000
Her total investment value at age 60: R4.97 million
Mark is 35 when he decides to start saving for retirement. He saves the same monthly amount as Xoliswa (R4 000) in a unit trust and earns the same average return of 8% a year. He starts later than he planned, but he's certain he will catch up to Xoliswa; he has 25 years until he retires. When he’s 60, however, he will have R3.7 million saved. Compounding did the trick for him too, but in total, he has contributed R1.2 million and has earned R2.5 million.
Total amount Mark contributed = R 1.2 million
His investment value at age 60: R3.7 million
Xoliswa's 10-year head start means she has over R1.3 million more saved, despite contributing only 40% of what Mark contributed (R480 000 versus R1.2 million). Ten years make a big difference! That is why it's important to start saving and putting compound interest to work as soon as possible.
Get started now
Don't panic if you haven't started saving yet. The most important thing is to start as soon as possible so you can get compound interest and time to work for you too.
This article is meant only as information and should not be taken as financial advice. For tailored financial advice, please contact your financial adviser.
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