Cashing in on compound interest is all about starting your savings plan early
To benefit from the power of compound interest the sooner you start saving, the better
All you need to grow a one-time investment of R100 000 to R1.7-million is time and the power of compound interest.
Ryan McCaughey, executive head of the Cape Town branch of financial planning firm Hewett Wealth, says that to earn R1.7-million you would need to reinvest the interest you earn each year on your R100,000 and to remain invested at a rate of 10% a year for 30 years.
To benefit from the power of compound interest, which will allow regular saving of quite small amounts to accumulate to a large sum of money, the sooner you start saving, the better, he says.
Any savings account or investment that earns interest or dividends delivers compound interest - if the interest or dividends are reinvested. The power of compound interest comes from interest being earned on the interest or on the dividends.
According to McCaughey, delayed saving can have a dramatically adverse effect, as illustrated by the following fictitious case study.
Jean invests R10,000 a year over 10 years - from age 25 to 35 - and then retains the investment until retirement.
Peter delays saving until the age of 35 and then saves R10,000 a year for 30 years.
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Ryan, the ideal investor, invests R10,000 a year to his retirement for his entire working career of 40 years.
If you consistently contribute towards retirement savings throughout your career, as in Ryan's case, you will be far more financially secure than someone who delays investing, McCaughey says.
But, he adds, it may surprise you that Jean, who contributed to her investment for only 10 years early in her career, ends up with more wealth than Peter, who saved for 30 years but started later.
In summary, the outcome for the three investors, based on an assumed growth of 10% a year are as follows:
- Jean, who invests R10,000 a year from the age of 25 to 35, ends up with R3,059,084 at retirement;
- Peter, who invests R10,000 a year from the age of 35 to 65, gets R1,809,434; and
- Ryan, who invests R10,000 a year for 40 years from the ages of 25 to 65, ends up with R4,868,518 at retirement.
Reinvesting the dividends you earn can achieve many of the same benefits that compounding interest offers, McCaughey says.
When you spend your dividends buying more shares which also accumulate dividends, you should also exponentially increase your wealth over time.
If you were to invest R100,000 in a dividend share that has an average annual return of 12%, which consists of a share price increase of 10% plus a dividend yield of 2%, and you reinvested the dividends over 30 years, your investment would be worth R2,995,992.
However, if you invested R100,000 in a non-dividend-paying stock with the same annual return over the same amount of time, your total investment would equate to only R1,744,940. That is a substantially lower return of R1,251,052, McCaughey says.
He adds that there are a number of key points to keep in mind to ensure compound interest works in your favour:
- Bear in mind small differences in costs and return matter.
- Consider increasing your savings by at least the inflation rate annually.
- Do not be tempted to squander the interest you earn instead of reinvesting it into your capital.
- Remember that time and patience allow you to achieve your financial goals.
To learn more, read part one of our online Money Guide on investing. This guide is sponsored by Discovery Invest.