This is where interest paid on an investment is added to your original sum then interest is again calculated on this total sum. Interest is added once again to the total, each time increasing the sum. Thus $1,000 at 5% becomes $1,050 after the first year, in the second year interest of $52.50 is again added becoming $1,102.50 and so on – unlike simple interest where the same amount of interest is paid on the amount each year.
To best explain let’s look at an example (please note for simplicity inflation is not included and the return is tax paid).
Brad and Simon are each given $10,000 by their grandfather. Brad puts his money away in an investment earning 5% while he travels around the world on his OE (overseas experience). Simon decides the interest would be a good source of pocket money and draws the interest as it is paid. He thinks he’s doing very well because he managed to get a rate of 5.5% which means he’s getting $550 every year.
Brad returns after ten years away. His $10,000 has now grown to $16,288.95 (interest $6,288.95). Although Simon was able to get an extra 0.5% he has only received $5,500 in interest and he’s used the money so all he has now is $10,000.
But beware…. Just as you can make money using compound interest so can the bank or credit card company. Yes, that’s right compound interest works just the same on debt.
Let’s take a look at another example – the early saver versus the late saver. Once again we use the magic of compound interest.
Jacqui and Carrie are old school friends. After attending academy together they decide to move overseas. Carrie spends the next 11 years working and living overseas but after a year away Jacqui returns. Jacqui starts a new job and saves hard for her new home. At the same time she is putting money aside for long term goals. It’s only $100 a month as she puts everything else into her home account. She receives an average of 7% p.a. on her money over the lifetime of the investment. After 10 years Jacqui stops her investment but leaves it to gain interest.
In the meanwhile Carrie returns and starts her saving plan of $100 a month. She saves regularly for the next 30 years earning the same rate of return as her friend Jacqui. This is what each of their savings looks like:
|No further deposits||Starts depositing each month|
|11||$18 361||$1 242|
|20||$33 756||$17 160|
|40||$130 626||$117 320|
|Total paid in||$12 000||$36 000|
You’ll notice that Jacqui has invested less over the period but has ended up with more at the end of the term – interesting don’t you think?
Here’s an easy rule you can use to work out how your savings or investments can grow with compound interest. This is called the Rule of 72. It is a rule of thumb and provides approximations but it is surprisingly accurate.
Here’s how it works: Divide the interest rate (or average annual return) into 72. The outcome tells you how long it will take for your money to double without further savings.
If, for example, you have $10 000 earning a constant rate of 6% interest (after tax) you would divide 72 by 6 = 12. This means every 12 years your $10,000 will double, so:
After 12 years you have $20,000 After 24 years you have $40,000
If you want to find out what rate of interest you will need to earn to double your money in say five years you would then divide 72 by the number of years being 5. This gives an answer of 14.4 so it would need to achieve a rate of return after tax of 14.4%.
Benjamin Franklin said, “Time is Money” and now you know just what he meant.