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The Power of Compound Interest
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Compound
interest is a fundamental component in the laws of money.
If
people were taught it at school as part of a money management unit, I
doubt that 95% of retirees would require the govt. pension for support
as they do today. If
all who learnt it applied it, far more than the current 5% of
people would attain financial independence.
Compounding
interest simply refers to the fact that the interest you receive will
be calculated not only on the principal amount that you invested, but also upon prior interest amounts
added to your investment.
Let's
look at an example. Back at the start of 1994, David invested $10,000
into a 15yr fixed interest fund paying 15% per annum. He has the
choice of either having the $1500 annual interest income paid into his
savings account, or of re-investing it back into the fund.
Here's
how much money he would make when his fund matures at the end of 2008
given both scenarios:
|
|
Interest
Paid Out Option |
Interest
Re-Invested Option |
|
End
Year |
Amount
Invested |
Plus
Interest Paid Out |
Amount
Invested |
Plus
Interest Re-Invested |
|
1994 |
$10,000 |
$1,500 |
$10,000 |
$1,500 |
|
1995 |
$10,000 |
$1,500 |
$11,500 |
$1,725 |
|
1996 |
$10,000 |
$1,500 |
$13,225 |
$1984 |
|
1997 |
$10,000 |
$1,500 |
$15,209 |
$2281 |
|
1998 |
$10,000 |
$1,500 |
$17,490 |
$2624 |
|
1999 |
$10,000 |
$1,500 |
$20,114 |
$3017 |
|
2000 |
$10,000 |
$1,500 |
$23,131 |
$3470 |
|
2001 |
$10,000 |
$1,500 |
$26,600 |
$3990 |
|
2002 |
$10,000 |
$1,500 |
$30,590 |
$4589 |
|
2003 |
$10,000 |
$1,500 |
$35,179 |
$5277 |
|
2004 |
$10,000 |
$1,500 |
$40,456 |
$6068 |
|
2005 |
$10,000 |
$1,500 |
$46,524 |
$6979 |
|
2006 |
$10,000 |
$1,500 |
$53,503 |
$8025 |
|
2007 |
$10,000 |
$1,500 |
$61,528 |
$9229 |
|
2008 |
$10,000 |
$1,500 |
$70,757 |
$10,614 |
|
Total
Interest Credited: |
$22,500 |
|
$71,371 |
|
Interest
Paid Out Option
Total
Return upon maturity (end 2008) |
Interest
Re-Invested Option
Total
Return upon maturity (end 2008) |
|
Initial
Amount Invested |
$10,000 |
Initial
Amount Invested |
$10,000 |
|
Interest
Credited |
$22,500 |
Interest
Credited |
$71,371 |
|
Total
Return |
$32,500 |
Total
Return |
$81,371 |
Simply by re-investing his interest, and making use of the power of
compounding, David has come out ahead by $48,871. Put another way, if
he had chosen to have his interest paid out to him, he would have
tripled his initial investment after 15 yrs. By reinvesting his
income, he was able to multiply it 8 times!!
As
we can see, the longer the period of time, the greater the benefit.
Below is the comparative table for David had he invested his funds
just 5 more years, into a 20 yr fund:
|
Interest
Paid Out Option
Total
Return upon maturity - 20yr Fund |
Interest
Re-Invested Option
Total
Return upon maturity - 20yr Fund |
|
Initial
Amount Invested |
$10,000 |
Initial
Amount Invested |
$10,000 |
|
Interest
Credited |
$30,000 |
Interest
Credited |
$153,665 |
|
Total
Return |
$40,000 |
Total
Return |
$163,665 |
The difference now, given just 5 extra years, is a staggering $123,665.
In other words, David has multiplied his initial investment 16 times
by re-investing his interest income, as opposed to only 4 times by
electing to have it paid back to him.
And
herein lies the key and power to compound interest. Anyone in our
prosperous nation can become financially free with sufficient time
– and given 3 keys:
-
That
you learn to live on less than you earn, and invest what disposable income
you have (George S. Clason in his book
 The Richest Man in Babylon
suggests you should set aside and invest a minimum of 10% of your
income)
-
That
you invest at a reasonably good interest rate (i.e. well above the
rate of inflation)
-
That
you start as soon as possible to put time on your side
If
a 20yr old starts investing just $100 per month ($23 p/w) at a return of 15% pa, by the time they retire at age 60 they
will have accumulated a sum of $2,455,144.63.
If
you're a 20yr old reading this, I urge you to start doing this now.
Don't put it off – the key to compounding is time. If you wait
until you're 30 to start doing this, you'll only have $599,948.30
by age 60 instead of
$2,455,144.63.
If
you're 40 or 50 and you're reading this, don't be discouraged.
You're obviously not going to be able to derive the same
benefit from compounding compared to a 20yr old, but start now
anyway – the sooner you start, the better off you'll be.
The
final question you may be asking is: where can I get a 15% return in
these low interest rate times? Well obviously, you won't get it by
putting your money into a term deposit at the bank. It's not my
place to provide financial advice - you should speak to a certified
financial planner for this. But I should say that 15% is not too
difficult to achieve even with limited financial know how.
The
Australian accumulated All Ordinaries index has historically achieved
close to this. Although the past cannot be taken as an indication of
the future, an equities index fund could be considered, such as an
ASX300 accumulation fund. This type of fund will give you a little
piece of all of the top 300 shares on the Australian market,
minimising your exposure to a downturn by any one company or market
sector.
Alternatively,
it's quite easy to find Australian blue chip shares that are paying
5% fully franked dividends at the moment – this equates to 7% or so
with franking credits thrown in. Add to that capital growth of another
7% or so per annum, and you'll be well on your way to achieving a
15% return with dividend reinvestment.
For
more sophisticated investors, it's not too difficult to achieve even
higher returns (such as, for example, selling call options over a
portfolio of blue-chip shares), but this
will require some time and effort to learn and is an active form of
investing as opposed to passive.
Finally,
once you've chosen your passive investment fund and have determined
the regular monthly amount you will be investing, put it on
auto-pilot. Set-up a periodical payment so that the amount is taken
from your bank account automatically every month and invested into
your fund. Try to start with 10% of your income as a regular
investment.
Stay
disciplined and don't dip into your funds for any reason short of
major crisis. Your funds should only be accessed once you've
accumulated a large enough sum that you no longer need to work.
Start today... and best wishes on your journey to becoming Financially
Free
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