“If you understand compound interest, you basically understand the universe.” (Robert Breault)
Don’t be simple
One of the best ways to understand compound interest is to know what it’s not — the appropriately named simple interest. This easy example illustrates the difference between the two.
Mr X decides to invest in an account that pays simple interest of 10% on his capital. He invests R1 000 000 for three years and ends up with:
Mrs Y, on the other hand, decides to invest her capital in an account that pays compound interest of 10% for three years:
In only three years Mrs Y earns an additional R30,000 by selecting an account that pays compound interest. But if they had both invested for ten years, the difference between the capital in the simple and compound interest accounts would be a staggering R593 742!
The underlying principle of compound interest is that you earn interest on an ever-increasing amount of capital, as opposed to only on the original capital amount.
Be sure to read the fine print
Not all compound interest is created equal, however, as the number of times the interest is paid on the growing capital makes a huge difference. If the compound interest is paid monthly, your capital growth will be greater than if it’s paid yearly.
Let’s apply this principle to the above compound interest example.
The more frequently the interest is paid, the greater the growth on growth.
The more often you contribute, the better
The number of periods is also very significant when contributing to an investment. The greater the frequency of your contributions, the greater the growth. Let’s look at an example:
The same applies to unit trusts
Unit trusts offer one of the easiest ways to reap the benefits of compound interest. By simply opting to reinvest the dividends you receive from your investment, your investment will grow exponentially.
Compound interest can be your enemy
As much as compound interest works in your favour when investing, it works very hard against you when you use debt. If you don’t pay off your credit card timeously, the amount owed is compounded monthly – meaning that new laptop could very easily end up costing you a lot more than you bargained for. A credit card balance of R20 000 which carries an interest rate of 20% (compounded monthly) will increase your debts by R4,388 in one year.
How to ensure compound interest works for you
Now that you understand how it works, it’s important to make sure compound interest is doing everything it can to improve your financial situation.
When investing in a bank account be sure to ask:
When investing in a unit trust:
There are many Future Value calculators online that can assist you to calculate how much compound interest you could be earning. Alternatively, ask us to crunch the numbers. Knowledge is power! Be an Einstein and take full advantage of the magic of compound interest to let your capital work hard for you.
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