The power of compounding
Albert Einstein reportedly said that the most powerful force in the world is compound interest. If you saved 15% of your salary from age 25, only a third of the benefit you receive at retirement comes from your contributions. The rest is from compound
However, like any powerful force, compound interest has the ability to both create and destroy. Compound interest also applies to debt which is why unpaid debts escalate at an ever-increasing rate and can soon become unmanageable. Harnessing the positive power of compound interest and avoiding the destructive effect of compound debt is the secret to creating wealth.
Compounding investment growth
Compound interest is the effect of earning interest upon interest. The table and graph below show the effect of an 8% return per year, compounded monthly, on a R1000 lump sum:
|
Investment |
Interest earned (8% a year) |
Total value |
|
|
Year 1 |
R1 000 |
R83 |
R1 083 |
|
Year 2 |
-- |
R90 |
R1 173 |
|
Year 3 |
-- |
R97 |
R1 270 |
|
Year 5 |
-- |
… |
R1 490 |
|
Year 10 |
-- |
… |
R2 220 |
The original investment has grown to R2 220. Compound interest has just delivered R1 220 that you have not had to work for.
Compound growth is even greater when you invest in growth assets like equities which, over time, provide higher returns than cash.
Based on the returns of the JSE over the last ten years a R1000 investment would now be worth R3500. That is R2500 created by the powerful force of compound growth.
Compounding debt
Compound interest works against you when you take on debt. Interest on debt is always higher than that on a money market investment because that is how banks generate profit. Banks also charge a risk premium for lending money.
When short-term interest rates (money market) sit at 5.5% the interest on short-term debt such as credit cards, personal loans and store cards is generally in excess of 15% making it a good investment for the loan provider but a poor choice for the borrower.
To put it in perspective, if you purchase an item worth R1000 today and settle the debt over 3 years, you would have repaid a total of R1248 due to interest (at 15% compounded monthly). You have paid 20% more for that item.
Many consumers get very excited when they can get a 20% discount on a sale without realising that you can get a 20% discount every day if you simply pay cash for the goods.
The compounding effect of interest on credit is exacerbated when you do not pay the monthly interest on your purchase.
For example if you purchased an item for R1000 at an interest rate of 15%, compounded monthly, and you were unable to meet your monthly instalments, by the end of the year you would owe the bank R1161.
· If that debt remains unpaid by the following year you will owe R1 347
· Within five years that debt will have risen to R2 107
· By year ten you will owe R4 440
If you compare this to your 8% a year investment which would be worth R2 200, it is clear that compound debt is by far the more powerful force which is why paying off your debts should be your first priority.
