The magic of compound interest

Cape Town - The concept of compound interest is at the core of all finance and takes place when the interest on a sum of money attracts interest itself, explained Mark MacSymon, wealth manager at Private Client Holdings.

It is the effect that causes money to rapidly snow ball or “compound” exponentially.

"Albert Einstein was quoted as saying, 'compound interest is the eighth wonder of the world. He who understands it earns it and he who doesn’t pays it',” explains MacSymon.
 
Compound interest requires two ingredients in order for it to be set in motion. These are reinvested interest (or earnings), and time.

If the interest on an investment is not reinvested, interest on interest cannot take place.

And unless committed for a significant length of time, the fruits of compound returns will go unnoticed.

MacSymon provides the following example:
 
Consider three people who experience the same annual return on their retirement funds.

- Kate invests R60 000 each year between the ages 25 and 35. In total she invests R600 000 over 10 years.

- William also invests R60 000 each year, but does so between the ages 35 and 65. In total, he invests R1 800 000 over a period of 30 years.

- George invests R60 000 each year between the ages 25 and 65. In total, he invests R2 400 000 over a period of 40 years.

"You will notice immediately that the contributions of Kate and William combined, equal the total contributed by George. Similarly, you would be correct to assume that George’s retirement fund value at 65, is equal to Kate and William’s combined," explained MacSymon.

The magic of compound interest is, however, best illustrated by the comparison of Kate and William’s saving experience.

Despite Kate contributing R1 200 000 less than William (R600 000 as opposed to R1 800 000), over a much shorter space of time (10 years as opposed to 30 years), her retirement savings are larger than Williams, at age 65.

The example illustrates the power of compound interest and the importance of saving for retirement sooner, rather than later.

- Fin24