Cape Town - You've probably heard the term before: compound interest. But do you really understand how this works?
Compound interest is what allows a very average saver to become a wealthy individual. What’s the secret? The value of compound interest is not in saving vast amounts – instead, it’s all about when you start saving.
According to Danelle van Heerde, head: advice processes and tools at Sanlam Personal Finance, it is important to understand the basic principle of compound interest.
“It’s effectively earning interest on interest on interest. So, once you have put your savings aside, however insignificant it may seem, you do not have to do anything, bar watch your money increase.
"It’s the best way for your money to grow over the long term.”
Van Heerde shows the strength of compound interest by taking a saving of just R250 per month. “For many savers, R250 amounts to a single trip to your local store to stock up on groceries.”
Put another way; imagine taking just R8 out of your purse daily, and setting it aside. How does compound interest work?
If you save R250 a month between the ages of 24 and 30, you will, according to Van Heerde’s calculation, have accumulated more at age 65 than someone who saves the same amount monthly from age 35 to 65.
In the first example, you have actively put away R250 for six years, or 72 months, amounting to R18 000 without interest. In the second, you’ve actively saved R250 for 30 years, or 360 months, worth R90 000.
And somehow you will still have more at age 65.
It works like this:
- If you put R250 away monthly between 24 and 30, and then leave those savings in your account, you’ll be worth R479 453 by age 65.
This is based on an interest rate of 9% (Van Heerde says this is calculated assuming 6% inflationary returns, plus 5% real returns, with 2% subtracted for fees).
- On the flip side, put away R250 between 35 and 65, and you’ll only end up with R425 528. “The difference is in the extra amount of time that your savings have to earn interest or compound, starting at age 24 instead of 35,” she says.
How can it benefit you if you’d like to save for your children’s education?
This lesson is an important one for parents in particular. School and university fees are becoming increasingly burdensome on parents – but making use of compound interest is a great way to reduce this load.
Here's how you can do it:
- By putting away just R250 a month for your child when he or she is between the age of 5 and 10, and then leaving that money in the account, your child will have about R50 000 at age 20 – a great way to help pay the fees.
- Or you can leave this to earn more interest, and by 65 your child will be worth R2.1m.
- Compare this to your child starting to save for himself as an adult aged 25 - an active investment of R250 between 25 and 65 will only amount to R1.05m.
“That’s double the saving, by simply putting away R250 every month for five years, when your child is young.
"It’s not surprising, looking at figures like this, that Albert Einstein referred to compound interest as the eighth wonder of the world.” What about inflation?
According to Van Heerde, there is one element to remain cautious of: inflation, otherwise known as the general rise in price of goods and services.
Inflation is currently running at 6.1% year-on-year. That means the interest you earn must be more than inflation, for it not to eat into the value of the money you’re saving. (For example, if your savings generate 5% interest, but inflation is at 6.1%, it means that you will be able to purchase less with your saving in future than you can today.)
Given the effects of inflation, where should you put your savings so you can experience the full benefits of compound interest?
Van Heerde says the first step is to check whether your company has a retirement plan in which you can save every month.
If not, set up a direct debit from your bank account to a good retirement savings product (which offers an inflation-beating investment return) as soon as your salary enters your account, to prevent you from spending it first.
You could also look into the benefits unit trusts or exchange-traded funds offer – two easy ways to invest your money, while allowing you to withdraw the money when you need it.
Van Heerde suggests speaking to an experienced registered financial adviser to help you find the best way of making the most of compound interest.
“Everyone’s situation is different, and an expert could help you find the best savings products for you. But even so, there’s no reason or excuse not to use the power of compound interest to benefit your savings strategy.
"It’s especially vital when you’re young, but even if you’re past 50 years of age, you can expect to live another 35-41 years, so don’t take that for granted.
"To think that setting aside just 35 cents an hour for your child when he’s five could make him a multi-millionaire when he retires – that is pretty empowering," Van Heerde said.
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