Compound interest, oh how you're so complicated yet so damn important. Why didn't we spend more time on simple and compound interest at school? It most definitely would make a big difference when it comes to trying to save/invest. Not only does it shows us how our money can grow, it shows us how very important it is to begin as soon as possible.
The graph below shows us the exponetial growth that compound interest gives us compared to simple interest. We need to leverage compound interest to our benefit!
Today, I'm going to take a shot at showing you how compound interest works in a different way. Unlike the graph above or the common online calculators, I want to look at some examples, with numbers, to paint a picture that I feel might strike you differently if you're struggling with the concept. This post is inspired by a number of podcasts and blog posts that I've come across that focused on showing us why getting to the first R100,000 is the hardest and most critical. This concept adapts well to that of compound interest, so grab a cuppa and let's dive into the numbers...
If you invest R10,000 per year into an investment account that yields 3% interest (highly conservative), it'll take you 8.88 years to get to R100,000. Now, if you invest another R10,000 the following year, you'll reach the next R100,000 (total = R200,000) in 7.02 years. The first R100,000 took 8.88 years whereas the next R100,000 took only 7.02 year. Each R100,000 takes less time to reach and that's thanks to compound interest.
Here's a walk-through example:
As you can see, the last R100,00, leading us to R1,000,000 only took 2.64 years! Compared to the first R100,000 which took 8.88 years.
How incredible is that?
There are a few things I need to mention:
One other thing I haven't mentioned is increasing the amount you save each year to combat inflation, which must be taken into account too. We should be increasing our yearly investment amount by at least 5% or so.
Awesome, right?
This is all about investing early and being consistent.
Now, we've focused primarily on 3% as a rate of interest return and that's really conservative. There are readily available money market accounts that offer more interest, let alone that of the likes of some ETFs. For example, the S&P500 has performed closer to 9% every year averaged out over the last several decades. Let's take a look at that in the table below to give you an idea of your annual R10,000 contribution against various interest rates:
Here's what we get when investing R15,000 per year:
Are you starting to see the power of compound interest? As your money builds and compound interest kicks in, so does it take you less time to achieve the next R100,000 each time. The best thing is to probably play around with this, using your numbers to see what's possible. Remember to go to File > Make a Copy in order to adjust the numbers.
If you're interested in looking at this through the use of a calculator, you can view my favourite compound interest calculator by clicking here. I've used this calculator for many years and it's really useful to play with. The calculator also gives a cool graph showing the deposits versus the interest gained, and as you'll see, the interest starts taking over - meaning you're making more money than you're putting in... that's where we want to be!
If you've enjoyed this and it's making sense, chances are you'll want to play around with the numbers, so I've created a Google Sheet that will allow you to change your annual investment amount allowing you to see what's achievable. You may access the sheet here, please use the menu to "Create a copy" for yourself if you want to play around as it'll be view only until you do that.
Understanding the power of compound interest, getting in early and living frugally is how you jump-start your investment journey. Several years now will make all the difference to your future, the sacrifise is worth it.
Have any questions? Pop them in the comments below and I'll do my best to answer them.