First consider simple interest, whereby the interest is only calculated on the original amount and not on the accumulated interest.
For example, if you save a R100 000 and receive 5% simple interest per year, after 5 years you would have received interest of R25 000.
In contrast compound interest is interest calculated on the original sum of money saved or invested, as well as on all the interest earned in previous periods on that original sum of money.
It uses “interest on interest” and is the result of reinvesting interest or dividends. The interest in consequent periods are calculated on the original amount plus all the previously accumulated interest.
If you save R100 000, as in the previous example, and you had re-invested this interest (or dividends or any investment return) the moment you received it back into the same investment, i.e. compound interest, you would receive R27 630 at the end of the period in comparison to only R25 000 with simple interest.
This difference might seem small, but over time compound interest can be a powerful force and turn relatively small amounts into substantial investments.
That is why people are encouraged to start saving as early as possible and make compound interest work for them by re-investing proceeds where possible.
With compound interest you earn interest on interest and over time the growth becomes exponential, which is why it is such a powerful force.
People with debt, especially short-term debt like personal loans and credit cards, will experience the opposite of the diligent saver.
Compound interest works against you in the case of debt and interest on debt becomes exponentially more over time, because you are paying interest not only on the original loan amount, but also interest on interest.
Using compound interest can be likened to the story of “The tortoise and the hare”. Someone starting early and investing steadily towards a goal – the tortoise – will eventually win the race. It might not be flashy and sexy – like the sprinting hare – but the strategy works.
Therefore, it is always advised to start investing as early as possible and for as long as possible.
As an example, John started saving when he received his first pay cheque at age 21. He saved R250 per month until age 65. Peter started saving when he was 40. He saved R450 per month until age 65.
Assume both investors earn a return of 11% (after costs) per year. In total, John saved about R132 000. Peter saved R135 000, or R3 000 more than John. Because John started so early, compound interested worked its wonders and at the age of 65 he has a total of about R2 800 000 saved.
In contrast Peter, who invested more than John, only has about R650 000 (about R2,15 million less than John.).
For Peter to have the same amount as John at age 65, he needs to save R1 940 per month from the age of 40, or 8 times more per month than John saved. He would have had to put about R580 000 away to get to John’s total, which John achieved with only R132 000.
People often delay starting to save and look for the one excuse after the other. If the example of John and Peter shows us anything, it is that the best time to start saving is now.
Compound interest becomes increasingly powerful over time, much like the snowball effect – a process that starts out small and builds on itself, becoming bigger and bigger as it gains momentum.
Investors like John, with a long-term savings goal, who starts early, contributes regularly and keeps their money invested, gets rewarded for their patience.