Reap the benefits of compound interest
• It’s important to start saving as early as possible to maximise returns, writes Lynette Dicey
It was Albert Einstein who called compound interest the “eighth wonder of the world”, saying that “he who understands it, earns it. He who doesn’t, pays it.” In a nutshell, compound interest is a mechanism that allows investors to make the most of their money and reap the rewards of patience, perseverance and consistency. Understanding and leveraging its power, says Nirdev Desai, head of sales at PSG Wealth, can be a game-changer.
Simple (or fixed) interest is a straightforward concept in finance that involves the accumulation of interest on a principal amount over a defined period. Unlike compound interest, simple interest is calculated only on the original principal amount and not on the growth of the principal amount over time.
If a client invests R100,000 in an account that pays simple interest of 10% on their capital for a period of three years, at the end of the investment period the simple interest earned on the investment will be calculated as follows: R100,000 x 10% x 3 (years), which amounts to R30,000. The total value of the investment would then be R130,000.
Desai explains that if the client were to invest the same amount of capital in an account that pays compound interest, the value of the investment would be greater than in the case of scenario A.
“After the first year, the interest earned would amount to R10,000 (R100,000 x 10%). In the second year, the client would earn 10% interest, but not on the same, original principal amount. Instead, compound interest would be calculated on the original capital value plus the interest earned in year one, in other words R110,000 as at the end of the first year. In the second year, the interest earned would amount to R11,000 (R110,000 x 10%), bringing the investment’s total value at the end of year two, to R121,000. Likewise, in the third year the compound interest would amount to R12,100 (R121,000 x 10%), bringing the total value of the investment to R133,100.”
The client earned R3,100 — or just over 10% more in cumulative returns — by opting for an investment with compound interest, he says, adding that it compounds even further with time.
“The underlying concept is that you earn interest on an ever-increasing base, instead of only on the original amount. While the differences may seem small in the short run, they can add up powerfully in the long run,” he says.
The true power of compound interest is time, says Desai, adding that the more an investment is left to grow and earn compound interest, the greater the earning potential becomes. This can have major implications on investments that are made towards saving for retirement or for other longterm goals with retirement annuities and tax-free savings accounts offering some of the easiest ways to benefit from compound interest.
“These investments are also both exceptionally tax-efficient
— if investors can commit themselves to having the discipline to make regular contributions, compound interest will do the rest,” he says.
He explains it using the
THE MORE AN INVESTMENT IS LEFT TO GROW AND EARN COMPOUND INTEREST, THE GREATER THE EARNING POTENTIAL BECOMES
following example: “Consider a retirement annuity with a set compound interest of 10% per annum with a 6% increase per annum over time. One investor starts saving for retirement at the age of 20 with a monthly contribution of R500. An investment term to retirement at age 65 is 45 years. The second investor, however, only starts saving at the age of 35 (investment term 30 years). At the end of the investment period, the accumulated value of the retirement annuity will be the same in both scenarios, but investor two will have had to contribute R2,500 per month to end up with the same amount as investor one at retirement. In other words, investor two would have had to invest 3.33 times as much as investor one to achieve the same results.”
This example, says Desai, demonstrates the importance of starting as early as possible when it comes to saving for retirement, but also the fact that time is the secret ingredient to making the most of the power of compound interest.
Advisers can help clients tap into this power and structure their portfolios in a way that aligns with their goals and maximises their returns.
“There are many complexities to a financial plan which is why it’s important to work with a qualified financial adviser who can help you structure your portfolio to get maximum returns and achieve your retirement savings goals.”