It’s rumoured Albert Einstein once referred to compound interest as;
‘The most powerful force in the universe’
Whether you believe this is true or not, one cannot argue that compound interest is a fundamental component of wealth creation and by understanding just this one principle, you can make a significant difference to your financial independence over the long term.
Compound interest means that you receive interest, not only on your initial investment, but also on the prior interest added to your investment. Sounds simple, but not a lot of people understand how powerful it is when applied or how the total return grows exponentially the longer the time frame.
Let’s use a simple example to illustrate the point.
Say you invest $10,000 into an investment returning an annual rate of 5%. You have the option of choosing to have the interest paid to you every year or re-invest it back into the fund. Which option would you choose?
Here’s how the investment would look after 10 year for each choice:
As you can see, the effect of compounding has increased the returns on your investment by $1,289 ($6,289 – $5,000) which is a 26% increase simply because you earned interest on your interest.
In addition you will need to consider the effects of tax, the risk of the investment and whether you can afford to re-invest the interest.
Exponential growth over long timeframes further increases the result, so let’s look at the effects on our initial $10,000 investment over a 40 year period.
If you continued your investment for 40 years and reinvested the interest, you would be $40,400 better off than if you took the interest out every year. You can see from the chart below, that compounding significantly increases your interest, through exponential growth.
What these figures are telling us is that the time factor is very important – the longer you have to compound the better off you will be. This means that it is a good idea to start saving as early as possible and even saving small amounts every week or month can make a huge difference. This is a fundamental feature of Australia’s superannuation system.
If you would like to know more please reach out for a chat.