In our daily lives, we come across and make use of compounds. Things like table salt, sugar, tea, and coffee are but to name a few. There are 1000s out there. Most of these are ingredients formulated into various products, a mixture of sorts. But – there’s another type of ‘compound’ out there which you may have come across. You’ve either experienced the negative side or a more profitable side of this compound. Let’s welcome… compound interest! And let's add - it's time you learnt how to use compound interest for good instead of feeling its evil counterpart dragging you into debt.
What is compound interest?
Compound interest is interest added to the original sum of a deposit or loan so that the added interest also earns interest from then on, compounded annually, semi-annually, quarterly, monthly, weekly, or even daily. This addition of interest to the original amount is called compounding. Simply stated, interest on interest.
Compound interest is a double-edged sword.
It's great if you're routinely saving money, but it can be cruel if you're borrowing money. Anyone can benefit from compound interest, you don’t need to be a wall street wizard. If you want your savings to compound as often as possible, time can be on your side, the longer your money compounds, the steeper it grows. In the case of debt, such as personal loans and credit cards, time is not on your side. Credit cards and other open-ended accounts use compound interest against you, that's why only making minimum payments are likely to keep you in debt for way too long.
The power of compounding.
Most South Africans, just like the rest of the world, are feeling the effect of compound interest on their debt and not on their savings, for whatever reason. If you want to see the best returns on your savings balances, you need to be comparing more than just interest rates. How and when interest payments are made can have a big impact on your savings potential.
Suppose you invest R10 000 into a savings account at a 5% simple interest rate for 3 years. The interest you earn each year will equal 5% times R10 000, which equals R500 or a total of R1500 of interest at the end of year 3. Now instead, let’s say you deposit the same R10 000 at 5% interest compounded annually. In year 1, the interest you earn is the same, R500. But in year 2 the interest you earn is 5% times R10 500, equal to R525. In year 3, you earn 5% interest on R11 025, equaling R551.25. In total, you earn R1576.25 in compounding interest as opposed to R1500 in simple interest, a difference of R76.25. Not much you’d say, but the effect of compounding really comes into play over longer time periods as the difference in interest becomes larger and larger.
The Bottom Line_
Compound interest requires you to sacrifice today to reap a benefit tomorrow. It's true that you'll need to do something to save a few Rands today. But, it's certain that the future reward will be greater than the sacrifice. You don't have to be rich to make compound interest work for you. The principal works the same whether you invested R100 or R100 million. The millionaire may have more investment options, but even the penny-less among us can use compound interest to their advantage.