Compound interest has been called the eighth wonder of the world, and with good reason. The power that this seemingly boring financial concept has to grow your money is nothing short of magical.
Suppose you have R1000 that you decide to save toward a goal you want to achieve 20 years in the future, like a great holiday or a comfortable retirement. There are three approaches you could take:
You could put that R1000 under your mattress for the next 20 years. However, this will actually cause it to lose value every year because inflation (the rising cost of living) makes your money worth less.
So with that in mind, maybe you choose to put your R1000 into a savings scheme that pays 5% ‘simple’ interest per year. At the end of each year you will get R50 (5% of R1000) in interest paid to you. At the end of 20 years, the total amount of money you have will be R2000 (the initial R1000 plus R50/year x 20 years). That may sound good now, but in 20 years time, inflation will mean that R2000 is not a lot of money at all.
So how can you make sure your money is worth a lot more in 20 years’ time? The answer is compound interest. If you put your R1000 into a savings account that pays 5% compound interest per year, by the end of 20 years, your R1000 would have more than doubled to over R2653!
How compound interest works
Compound interest allows you to earn interest on your interest. At the end of the first year, your 5% interest would make your R1000 worth R1050. Then, for the next year, you earn 5% interest on that bigger amount. In essence, you are actually earning interest on the extra R50 you made in the first year. And each year after that, the amount of ‘extra’ money that is earning interest for you grows bigger and bigger.
And the longer you leave your money untouched, the higher the amount it grows for you. If you leave your R1000 in the savings account for another 20 years, by the end of the total 40 years your R1000 will have grown to more than R7000 without you ever adding another cent to the initial amount you deposited!
Three ways to make compound interest work even harder for you
- Keep adding to your savings – If you make a single deposit and leave it, compounding will grow your money. But if you also keep adding to your savings whenever you can, that growth will be much quicker, and much higher. If you can, make it a habit to add to your savings every month.
- Start as soon as you can – The effect of compounding gets even more spectacular over time, because the amount of interest added to your savings gets bigger and bigger. And remember, the next best thing to starting young, is to start now.
- Leave it alone – for compound interest to work, your money needs to stay in the savings account. Don’t give up, or give into temptation. Set a time goal and then stick to it. The returns may seem small at first, but eventually, you will be so happy that you had the discipline to keep saving.
Put compound interest to work for you today
July is savings month in South Africa. That means there’s no better time than right now to put the power of compound interest to work for you. Even if you can only start small, with compound interest on your side, that bit of money you put away every month could grow into a very healthy sum in a few years’ time.