When you invest over a period of time, compound interest is your best friend. In effect, it means you are earning interest not just on your own capital, but also on the interest you’ve already earned. Over the long term, this might be phrased as “interest on interest on interest on interest on interest …” or more simply, “free money”! So how do you get this free money? This is how…
A simple start
Imagine we place $100 in an investment that earns 10% pa. At the end of one year, we’ve earned $10. Imagine we spend all the interest we receive. At the end of each year, our investment amount is back to $100. That’s simple interest. At the end of 10 years, we’ll still have our $100, and we will have received a total of $100 in interest.
I = P(1+r)n-P
Don’t worry, we’ll do the maths for you, but this little formula contains a power that Albert Einstein is attributed to labelling “the most powerful force in the universe”. It calculates our net profit when we earn interest on the interest. That’s what compounding is all about.
Going back to our first example: if we re-invest the interest on our original $100, at the end of the first year we will have $110. Leaving it invested at 10% pa, we’ll earn interest of $11 in the second year, bringing the total in the account to $121. If we keep going for 10 years, our investment will grow to $270.70 – that’s our original $100 plus $170.70 in interest.
Time is money – literally
This example may not seem so impressive, but the power of compound interest really shines over the long term. Looking at our simple situation and taking the interest out each year for 30 years, we will earn a total of $300 in interest. But relying only on the compounding of the interest (ie. no other deposits are made), the total interest earned over the same time would be $1,883.74.
A child born today could easily live to 100. Simple interest on a $100 investment would amount to $1,000 over their lifetime. Left to compound untouched at 10%, that same investment would grow to $2,113,241! Even on such a small initial investment, that’s an incredible difference!
The other critical factor is the actual rate of earnings. If the earnings rate dropped just 1% to 9% pa, our hundred-year investment would grow to “only” $783,548.
A couple of drags
But don’t forget to take into account tax and inflation. They act as drags on our investment performance.
Let’s assume investment earnings remain at 10% pa and are fully taxable. What will our $100 grow to over 30 years at different tax rates?
(Top Tax Rate)
* Includes Medicare levy and 2% debt levy.
As for inflation, even at a rate of 3% pa, you’ll need $2.43 in 30 years’ time to buy something that costs $1.00 today.
There are many ways of minimising the effects of tax and inflation. Picking the right tax environment is clearly important. Capital gains are only taxed when an investment is sold, so growth assets have an advantage over those that only produce income. They also cope better with inflation.
Always remember, seeking higher returns generally involves taking higher risks but some of those risks can be managed with an effective and professionally constructed investment strategy.
If you want to take advantage of “the most powerful force in the universe”, talk to us now.
Assumption on calculations: interest is compounded monthly.
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