The Magic of Compounding Interest
“Compound interest is the eighth wonder of the world. He who understands it, earns it…He who doesn’t…pays it. Compounding interest is the most powerful force in the universe”
– Albert Einstein
You may have heard this quote before (probably from me). It is a quote I often used to show that compounding interest is the most important thing in finance.
A regular savings plan can turn small amounts of money into a significant sum that can take you closer to your dreams much faster. All that’s needed is time and discipline.
For example, let’s see what happens to an investment starting with just $100 and adding $100 each week from your regular income.
The table below shows what the investment value would reach after five years and up to thirty years. In this example, we have assumed that the investment pays a return of 5% per year (paid quarterly).
| 5% return | |
|---|---|
| 5 years | $29,598 |
| 10 years | $67,454 |
| 15 years | $116,037 |
| 20 years | $178,386 |
| 25 years | $258,402 |
| 30 years | $361,092 |
Regular savings plan of $100 per week compounding monthly.
The results show that a regular savings habit can turn small sacrifices into real outcomes.
| 5 years | 10 years | 15 years | 20 years | 25 years | 30 years | |
| 5% return | $29,598 | $67,454 | $116,037 | $178,386 | $258,402 | $361,092 |
Regular savings plan of $100 per week compounding monthly.
The results show that a regular savings habit can turn small sacrifices into real outcomes.
To budget or not to budget
Think about what you might have to do in order to save $100 per week to add to your investment. Maybe instead of eating out every week, make it a special monthly event. Taking lunch to work is a big saver – or you could cut back on your coffee purchases if you’re a regular at the local café.
Review essentials such as your mobile phone plan and utilities to get better deals and direct that extra cash straight to your investment.
It might sound picky, but in return for this self-restraint you can see what can be achieved:
- the $29,000 in 5 years might go towards a deposit on your first home or an overseas holiday;
- the $67,000 in 10 years might contribute to your young children’s secondary or tertiary education; or
- the extra $258,000 in 25 years might help you to retire more comfortably or earlier than you thought you could.
Any of these goals would seem to make your small sacrifices extremely worthwhile in the long run. And remember to write down your financial goals as early as you can because it’s much easier to make those sacrifices if you know what they are helping you to achieve.
Reducing expenses is not the only way to find a spare $100 each week. Another good time to start a savings plan is when you receive an increase in your disposable income from a new job or a pay rise. Before you spend the extra money, put it away.
The trick is to start soon
Everyone’s ability to save is different. If you can’t save $100 every week, the above figures are still worthy of your attention. For example, if you can save $50 per week simply halve the results in Table 1. Conversely, if your savings capacity is higher, multiply the figures.
The results also demonstrate the effect of time and compounding returns on the value of your investment. The sooner you start, the less you need to save in order to achieve the same outcomes.
Automate
A great trick to help you save is to simply put your finances on auto-pilot.
Through your internet banking, set up an automatic transfer to your savings account or investment fund when you get paid, and you won’t even know it’s missing.
The difference 10 years can make!
Christine is 40 and she wants to retire 20 years from now, so she starts saving an extra $100 per week for this goal. Based on our simple calculations she might expect to have an investment of around $178,000 to add to any other superannuation or retirement benefits she has at that time.
Christine’s twin Ben also plans to put down the tools in 20 years, but he is confident that he can save more money than his sister. So Ben ignores any type of retirement planning for the next 10 years. He then saves twice as much as Christine – $200 per week – for the last 10 years of his working life.
Assuming a 5% return on the investment, the difference is staggering. By starting 10 years earlier, Christine will have saved just over $178,000 compared to Ben’s outcome of $134,743.
Even though his regular savings amount totals exactly the same as his sister ($104,000 over the period of the investment), Christine has benefited from the compounding investment returns on her money over a longer period of time, earning an extra $44,000 in interest – or better known as “free money”!
Another way to look at it is that Ben would need to save $265 per week for the last 10 years of his working life (a total of $137,800) to end up with the same outcome as Christine.
And finally...
The examples we have used here are aimed at highlighting the benefits of time and discipline when it comes to investing in a regular savings plan. To keep things simple, we have not taken into account other factors that will impact on the outcomes you can achieve, such as taxation, fees and differing investment returns. These factors are nonetheless important and will need to be considered when you are deciding on the type of investment you choose for your regular savings plan.
Higher-interest bank accounts, managed share funds and superannuation are just a few ways to implement a regular savings plan like the one we have examined here (although you won’t find any at call bank accounts that pay close to 5%pa at present!). The type of investment that is best for you will depend on your own specific circumstances, including your goals, time frames and attitude to risk (volatility).
You can start a compounding savings plan on your own or talk to us – we can show you some great investment options to help you achieve your dreams sooner.