The power of compound interest

The great Nobel Prize winning physicist Albert Einstein once said, "The most powerful force in the universe is compound interest." And he knew what he was talking about.

The wealthy use the principals of compound interest to increase their wealth and money lenders use it to maximise their profits. In fact, it would be fair to say that if more people understood how it worked, particularly from a young age, then more people would be better off and enjoying greater financial independence.

How does it work?

So exactly what is compound interest? Simply put, it's where you earn interest not only on your investment, but also on the interest added to your investment.

Let's look at a simple example. Say you could invest $10,000 into a managed fund for ten years at an annual interest rate of 10%. You can choose between having the interest paid to you each year and re-investing it back into the fund. Which option would you go for?

Here's how your investment would look after 10 years under each scenario:

As you can see, the effect of compounding is to increase your return by $5,937 ($15,937 - $10,000) or by over 50%, because you earned interest on your interest. Looking at it another way, you would double your money if you opted to receive your interest each year, where as it would go up around two and half times if you decided to re-invest it.

Of course when deciding which way to go you have to take into account things like the relative rates of return, you tax position, the underlying risk of the investment and whether you can afford to re-invest the interest. But these considerations aside, the effect of compounding is to greatly increase your investment return.

Exponential growth

The thing about compounding, is that the longer the time frame, the greater the return. In fact total return grows exponentially. Let's use our example above to see what would happen if we kept our $10,000 invested for a longer period.

As the table above shows if you kept your investment going for an extra five years the growth in your investment would jump from 2.6 times after 10 years to 4.2 times after 15 years equivalent to an extra $15,832 ($41,772 - $25,937) in earnings.

Significantly, as each year goes by, the rate of growth gets bigger and bigger until after thirty five years your investment has grown a massive 28.1 times compared to a more modest 4.5 times if you'd opted to have your interest paid out annually.

Start saving early

What this is telling us is that time is important - the longer you've got the better. This means it's a good idea to start saving as early as possible. This is especially important for our younger generation who may not be thinking too much about the future or have much spare cash lying around. Even saving small amounts a week can make a big difference.

Let's take the example of Brad and Janet, both 22 years old and both working. Each has a spare $1,000 per annum they can either invest or spend. Brad decides to save his $1,000 a year and earns an average 10% per annum over the next 43 years. Janet decides to spend her $1,000 until the 11th when she decides it's time to start saving. She also earns a return of 10%. How much would each have saved by the time they're 65?

Brad savings schedule looks like this:

Whereas Janet's looks like this:

So by starting 10 years earlier Brad has saved a staggering $407,164 more than Janet - represented by his $10,000 in extra savings and $397,164 in extra interest. This is the power of compound interest!

So if you're a young person reading this column think seriously about starting up a savings plan, no matter how small your initial savings amounts might be. Don't delay - the sooner you start the better. And if you're an older reader, don't be discouraged. You can still reap the benefits of compounding interest but of course they won't be as great as those who started saving earlier and/or for a longer period of time.

Types of investments

To maximise the benefits of compounding you need to identify investments that provide good rates of return (certainly above the rate of inflation) and allow capitalisation of earnings (ideally more than just annually). Some examples of investments that may provide compounding returns include:

• Superannuation
• Shares - look for dividend re-investment opportunities
• Property
• Managed funds
• Savings accounts - these usually provide for lower returns but income is normally compounded monthly

Going forward

To maximise the benefits of compound interest you should think about:

1. Saving as much as you can on a regular basis. Consider setting up a direct debit from your salary so you're not tempted to spend your cash. If cash is tight, put together a budget and look for savings. Remember, you can get some big long term benefits from even a small savings amounts.

2. Look for investments with a reasonable interest rate remembering to balance risk with reward. Think about flexibility (i.e. how easily can you withdraw your cash) and consider how often earnings can be compounded. Always consult your financial adviser if you need help or you're not sure.

3. Start saving as soon as possible - the sooner you begin the greater the benefit. And remember to encourage your kids to start saving at an early age. This will help them develop good financial habits which will benefit their long term financial wellbeing.