I have a small confession to make, I love compound interest!
Let’s be honest this is arguably the first money lesson that we are taught however I would argue that in the 20 years I have been working as a financial planner, this concept is still foreign to many of us.
A refresher, compound interest can simply be described as interest on interest. For example, you make an initial deposit into a savings account or share portfolio and the interest earnt on this account is then added to the initial amount invested. Then, you start to earn interest on both your initial deposit and the interest you have earnt hence providing a better result. This cycle continues and this is what we call compound interest.
Why is the concept of compound interest so important? Well you see, in our lifetime, we will either receive and benefit from compound interest or we will pay it through a debt facility. At either end of this spectrum the impact can be significant.
To illustrate the benefit of compounding interest, the following scenario illustrates an investment of $5,000 and a deposit of $1,000 per month over a ten-year period. The blue line illustrates no interest being received as compared to the orange line which illustrates a 7% rate of return, compounding over ten years.
The end outcome, over $50,000 in interest received over a ten-year period. I still marvel at the power of the compounding rate of return over time.
What’s more, compounding interest can have a benefit for people who are accumulating wealth and for those who are drawing on their assets to fund an income stream in retirement. The key point is to ensure that the asset allocation of your investment portfolio is structured in such a manner that accounts for your lifestyle requirements and objectives and allocates the balance to an asset class that will provide a compounding rate of return.
To conclude, my advice to you, is to start now, your future self will thank you for you it……