Understanding the Magic of Compound Interest early on in your investing life will offer a tremendous impact on your long term wealth plans. Do you know what compound interest is, and how it actually works?
In the most basic of terms it is interest earning interest. For instance, let's imagine that last year you banked R100 and over the past twelve months it earned R2 in interest. Going into the new year you will now be earning interest on R102, the total of your original deposit and the interest it has earned so far. Now of course this may not seem like much but a simple example like this is an easy way to demonstrate how compound interest works, and that simple understanding can have a major impact on your financial future.
Understanding the Magic of Compound Interest
How is this helpful to you? Because you can turn a small amount of money into a much larger lump sum over time. That's why some people refer to compound interest as a financial magic trick. But its benefits (and occasional drawbacks) are very real. Let's take a look at some of the other important things you should know about it:
Understanding the Magic of Compound Interest
Anyone Can Benefit From Compound Interest
You don't have to be an investment whiz, and you certainly don't need to be a member of the wealthy jet set, to benefit from the 'magic' of compound interest. All you need is an amount of money you can afford to save, an interest bearing account of some kind, and the patience to leave that money in place for some time. The longer the money sits, the more you make, so if you are saving for a specific goal - retirement for example - then the earlier you get started the better.
Understanding the Magic of Compound Interest
Compound Interest Adds Up a Lot Faster Than You Think
Going very small again, lets say that you decide you can afford to invest just R5 per month. The money earns 5% interest that is compounded each month.Keep investing the same amount at the same interest rate for ten years and, from your own pocket you will have invested R600. However, your account balance would be R776 and even if you were to stop right then in another 15 years that would have grown to over R1,500. Now adjust those numbers up a bit - you don't have to go too high - and you can see how investing a small amount of money early - say when you are 25 - can leave you in a very comfy position when it comes time to retire.
Understanding the Magic of Compound Interest
Time Is, and Isn't On Your Side
Compound interest can also be bad for you, as credit card companies and other revolving creditors use compound interest when they are calculating the interest on your debt. That's why by just paying the minimum due every month you are unlikely to ever get out of debt. If you do carry credit card balances though, compound interest can be made to work for you.Let's say that your credit card company charges 14% interest on balances. By adding a measly R5 to your payment every month you'll save R1,315 in interest payments over the next ten years as you pay that balance down.
Understanding the Magic of Compound Interest
The Higher the Interest Rate, the More You Earn
This one is a little bit of a no-brainer. But still people do not always take advantage of this extra way to grow even more money via the 'magic' of compound interest. The average, run of the mill bank savings account may offer a reasonable rate of interest, but there are almost always other options out there that earn even more. Take the time to shop around - consult with a financial advisor - to find the savings instrument that offers you the very best chance to use the concept of compound interest to secure yourself a brighter financial future.
