For Richer Or Poorer
Compound interest can get you rich faster. But it can also get you into debt faster. Way, way faster. Paul Gregory explains the power of the maths.
18 October 2021
JUNO Autumn 2021
What is compound interest and why is it so great? ‘Compounding’ is re-investing the money you
earn on investments – your return – instead of spending it.
When you re-invest your return, your pool of money increases. With more money invested, the impact of any returns you get is bigger: a 5 per cent return on $10 is 50 cents, but a 5 per cent return on $10,000 is $500.
The return rate is the same but, applied to a far larger sum, your financial benefit is much greater.
The longer you’re disciplined about re-investing returns, rather than spending them, the more powerful the compounding – or ‘snowballing’ – effect.
Here’s a simple example of how compounding works:
Say you have $100 and get a 5 per cent return a year for two years, but don’t reinvest the return. After the two years you have $110 – the $100 you started with, plus $5 for each of the two years you were invested.
If you reinvest the return, you have $110.25. Why? Because at the end of first year you have $105 invested, not $100 like in the first example, because you reinvested the $5 interest rather than spending it. A 5 per cent return on $105 is $5.25.
An extra 25 cents might not seem like much, but extend that difference over time and it will add up to a far greater amount, quite quickly.
If you’re disciplined about reinvesting returns, your investment will, over time, build to a size where it gains its own momentum.
The returns you get on it, because of its size, will eventually be larger – perhaps far larger – than the contributions you’ve made.
If you’re disciplined about regular contributions, too, this effect can be even more rapid.
Try an exercise, called ‘The rule of 72’, which is a quick way to estimate how long it will take to double your money – an idea anyone can understand! – through compounding.
Note that the rule is usually accurate, as long as the return rate you use is less than 20 per cent.
Take the return on your investment. This might be fixed on a term deposit or a bond, or a reasonable expected return on shares (which is not guaranteed). Let’s use the expected return on a KiwiSaver Growth Fund over time, 4.5 per cent annually, from the regulations governing KiwiSaver calculators.
Divide 72 by the interest rate.
With a 4.5 per cent annual return, you’d expect to double your money in 16 years if you reinvest your returns.
While 16 years might sound like a long time, a lot of investment goals are long-term.
Retirement can be many decades in the future, depending on your age. Even a first home for a teenager, or someone in their early 20s, is fifteen to twenty years away.
Why credit cards are a bad idea
Unfortunately, compound interest also works against you, with debt, just as fast, or even faster.
Let’s use credit cards as an example. If you don’t pay off your credit card 100 per cent within the interest-free period, interest is charged on what’s left, boosting the size of the debt.
If you fail to pay off the full debt the next month, interest is charged on the debt you incurred, plus the previous month’s interest. And so on.
Compounding is especially bad with credit-card debt because the interest rate is typically very high – 20 per cent or more.
Let’s return to the rule of 72 to show how it works.
Let’s say you have a no-frills credit card (no Fly Buys, no travel insurance) charging a lower rate of interest, like 15 per cent. If you don’t pay off your debt, the rule of 72 applies:
15 per cent
Divided by 72
The debt doubles in less than five years.
Because the interest rate is higher than the expected return on a KiwiSaver Growth Fund, the debt grows much faster than the investment.
And while returns are not guaranteed on any investment, you will ALWAYS be charged the interest rate on debt.
JUNO’s content comes from sources that JUNO magazine considers accurate, but we do not guarantee its accuracy. Charts in JUNO are visually indicative, not exact. The content of JUNO is intended as general information only, and you use it at your own risk.
Informed Investor's content comes from sources that Informed Investor magazine considers accurate, but we do not guarantee its accuracy. Charts in Informed Investor are visually indicative, not exact. The content of Informed Investor is intended as general information only, and you use it at your own risk.