LOUISE FAIRSAVE: Compound interest
Before going any further in considering investing, it is important to understand how compound interest works and how to use this marvellous income-earning system in your favour.
A simple example: A sum of $5 000 invested at a 10 per cent interest rate over a five year period on a simple interest basis or on a compound interest basis. The following table sets out the results:
The first column sets out the years of investing. Column 2 sets out the amount accumulated with the original sum each year on a simple interest basis. Column 3 sets out the amount accumulated with the original sum each year on a compound interest basis. Column 4 sets out the difference in amounts earned per year between the two approaches – simple interest and compound interest.
The earnings row totals the incremental amount accumulated by the end of five years.
On a simple interest basis, you will earn 10 per cent of the original sum invested for every year invested.
In this example, that is 10 per cent of $5 000 = $500. Therefore after five years you would have accumulated 5X $500 or $2 500.
On a compound interest basis, you will earn 10 per cent on the amount accumulated at the end of each year. So in the first year, you will earn 10 per cent of the $5 000 = $500. So at the end of the first year, the balance is now $5 500 on which you will earn 10 per cent over the second year. So, by the end of the second year the amount accumulated is $5 000 + 10 per cent of $5 500 = $5 500 + $550 = $6 050. Similarly over the 3rd year, compound interest will generate another 10 peer cent of $6 050 = $605, bringing the fund to $6 050 + $605 = $6 655.
Repeating this process, compound interest accumulates $8 052.55 by the end of five years. The difference in accumulation between the two systems
is $552.50. Therein lies the attractiveness of the compound interest system. Once you invest your money, you would expect to earn at least simple interest. With compound interest or compounding, you now have additional money (the amount in the Extra column) that will now generate additional interest earnings for you each year. This is money, unlike your original investment, that you did not have to drive a stroke to earn.
You can observe that the Extra column amount grows bigger and bigger every year, providing more earnings to earn more and more each year. So the longer you leave your money, and the higher the interest rate, the greater will the accumulation of extra earnings accelerate.
For example, after 10 years you will earn an extra $2 968.71 by compound interest system. The longer the period, the greater the fund grows: in year 30 on a simple interest basis, you would have accumulated $20 000. On a compound interest basis, the balance would be $87 247.01.
You not only have accumulated a significant sum through compounding, you also have an additional $67 247.01 that you did not work for going forward on a compound interest basis to earn you additional money.
Louise Fairsave is a personal financial management advisor, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances.