Albert Einstein is reputed to have said:
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Whether he did or didn’t say this, interest has rather an interesting role to play in our lives.
Firstly, let us work out what compound interest is.
When you put money in the bank or savings deposit, the bank pays you a certain amount back on that amount. For example, assume you deposit R10,000 into a savings account that pays you 5% interest per year. Your interest payment for the year is R500. This might not sound like a lot. However, look what happens now.
Compound interest is interest on interest on interest. It’s the interest calculated on the initial principal amount, but also includes all the accumulated interest.
Let’s go back to the original example. You have saved R10,000 and it is in a savings account that earns you 5% interest per year. At the end of year 1, you have R10,500. In year 2, instead of only earning interest on R10,000,you earn interest on R10,500. So, you earn R525 which you add to your savings account and you now have R11,025 in the bank. At the end of year 3, you earn interest on the amount R11,025 which is R551 and now you have R11,576 in your bank account.
This still might not sound like the 8th wonder of the world.
The Key Requirement for Generating Compound Interest is TIME
Each time you earn interest on interest, you are earning exponential growth. Each year you earn more than the year before, the rate that your bank account increases by each year is more and more. So if you allow the R10,000 to compound for 20 years at 5% per annum, you would have R26,533. If you allow R10,000 to compound for 30 years at 5% per annum you would have R43,219.
Don’t take our word for it, try it out for yourself. There are some great savings calculators online. Something to have a look at is if you added an extra R100 each month to your savings account on top of the R10,000 you originally saved. Try out different starting amounts, interest rates, and over different periods of time to give you a real sense of what compound interest can do.