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There’s a quote often misattributed to Albert Einstein that compound interest is the “eighth wonder of the world”. While savings accounts may not stack up to the beauty of the pyramids, the amount of power compound interest can have over your financial life shouldn’t be underestimated.
In fact, compound interest is one of the fundamental principles of creating wealth. By simply understanding this one principle of investing, you’ll set yourself on the path to success by thinking about long-term, rather than just short term rewards.
Consider someone who invests $5,000 each year between the ages of 20 and 30. Put to work in a managed fund or a balanced share portfolio, (assuming a 7% annual return), by the time this investor reaches the age of 60, they would have just over $380,000. And they only invested $50,000 of their own money.
In contrast, someone who saves $5,000 each year, for that same 30 years, will only have $150,000.
They’re both great results. But consider how the power of compound interest helped the first investor. Even though the first investor put away just 10% compared to the second, they still ended up with a larger amount of money. That’s the power of compound interest.
When you start saving has a greater impact on how much you save. The sooner you start, the sooner you’ll have that compound interest working for you. If you start saving early enough, with the right amount, there’s no reason you can’t reach a balance of $1 million or more in retirement.
But there are some principles to keep in mind whenever you’re dealing with interest, particularly if you’re evaluating the terms on investments or different savings accounts.
The first is that the regularity of the compounding will affect your balance significantly. Does the investment compound annually, or only semi-annually? This may change your outcome to a drastic effect.
It’s also important to distinguish compound interest from simple interest. Compound interest refers to interest that is paid on both the principle, and any subsequent interest payments added to that principle. Think of it as “interest paid on interest”. Simple interest, on the other hand, is interest that is paid only to the principle amount. Interest added on top over time isn’t taken into account.
While compounding interest can be one of the great tools for an investor, it can also be an enemy. Debts including credit cards and mortgages carry interest that will compound over time – which is why paying the minimum amount on a debt balance will take you longer than you realise! As a result, it’s always good to pay more than the minimum amount to fight the effects of compound interest.
This is exactly why refinancing the interest rate on your debt can be such a powerful tool, especially in the case of a home mortgage. A fraction of a percentage point can save thousands of dollars over the lifetime of a loan. The same goes for finding the savings account with the highest interest rate.
Compound interest is a great tool – but it can work against you. Understanding its power on both your savings, and your debt, is critical to obtaining financial freedom and developing a plan to create more wealth.
At Maddern Financial Advisers, we want your money to work as hard as it can for you. Speak to us about how you can start taking advantage of compound interest – and put your money to work.
Disclaimer: The information on this site is of a general nature only. This is not a recommendation or endorsement of any product or investment. It does not take your specific needs or circumstances into consideration. You should look at your own personal situation and requirements before making any financial decisions or consult the advice of an accountant or financial adviser.