Even if you don't know what it is or how it works, you've probably heard of compound interest. It's a term used by money-savvy people – people who have been 'clever' enough to use this tactic to grow their savings significantly. But compound interest isn’t something that can be used only by money-savvy or wealthy people. Compound interest is a simple concept that anyone can use to turn even modest savings into a small fortune. In this article, we explain how.
Simple vs Compound Interest
What is simple interest?
To understand compound interest, you first need to understand simple interest, and that’s, well… simple. If you put R500 into a savings account and earned 10% interest per year, for 2 years without reinvesting the interest you earn, ’you'd earn R50 in interest at the end of the first 12 months and then another R50 at the end of the second 12 months, giving you a total of R100 rand in interest earned on the R500.
What is compound interest and how does it work?
Compound interest is interest earned on your interest. Using the same example, your savings at the end of the first year would be R550, so in year two, you wouldn’t be earning 10% interest on your initial R500 only but on R550 (your initial savings deposit plus the interest earned in the first year). That would give you a total R55 interest for year two only and a total of R105 at the end of the second year.
An extra R5 isn’t much, but what would happen if you then reinvested your interest for another 10 years? You'd earn 10% on R55, then 10% on R60.50, (R55 + 10%) then 10% on R66.55 (R60.50 + 10%), then 10% on R73.20 (R66.00 + 10%) until you were earning interest on R142.40 and had accrued a total of R950 in interest. Compare this to the R500 in simple interest that you would have accrued over 10 years if you hadn’t reinvested your interest .
Now, imagine that you didn't stop at a single deposit, but continued to make monthly deposits of R500 at 10% interest per annum for 10 years. All of a sudden, you're looking at a very different figure: a balance of R104,630, of which R44,130 is interest. These calculations were generated by The Calculator Site.
What it takes to make compound interest work
To make compound interest work for you, you really need only three things:
- An interest rate that beats inflation,
- Money to deposit into your account, and
- Time.
It's important to look around for the most competitive interest rate from a reputable financial institution as this will ensure that your interest outpaces inflation and gives your savings real growth. And it's equally important that you leave the interest earned in your savings account to earn interest on your interest. Better yet, keep making monthly deposits to build a nest egg like in the example above.
And then, of course, you need time. The longer your money sits in a savings account, the more interest it accrues. At times you'll need to practice great self-discipline to stop yourself from reaching into your savings, but in the end, your hard work will be worth it.