Albert Einstein once said that “compound interest is the most powerful force in the universe”. Probably. Who knows. The renowned physicist is attributed with saying all sorts of things. But wherever that quote comes from, it’s not wrong. In this article, I hope to explain to you that understanding the time value of money and how compound interest affects you personally is the single most important concept you will ever learn.
The TL;DR version goes something like this. Money now is good. It can buy gelato, tickets to gigs, trendy clothing (not birkenstocks), holidays or heaven-forbid, smashed avo on mixed grain, gluten-free, taste-free, fun-free bread. But money later is better. If left alone, stashed under the bed, it’s worth less than money today because of a pesky little phenomenon called inflation (which we look at in Economics 101). But if invested right, money later is worth a lot more than money today.
We’re taught how to calculate compound interest in school, but it’s never explained to us just how valuable it can be. The best way to explain it is with an example. Imagine you deposited $1,000 into a bank account, which paid you interest at a rate of 5% per year. After one year, you’d have $1,050 (having earned $50 in interest). If the interest is compounded (interest on interest), then during the second year, you multiply your interest rate by this new figure of $1,050, instead of the original $1,000 figure you first deposited (which is what you would do if you were earning simple interest). The table below sets out example interest calculations for both simple and compound interest if you’d invested $1,000 at a rate of 5% for 10 years:
|Year||Simple Interest ($)||Compound Interest ($)|
I want you to pay close attention to the exponential effect of compound interest. The graph helps us visualise this effect. Between Year 0 and Year 1, we earn a mere $50 in interest. But between Year 9 and Year 10, we earn $78 in interest. This may not sound like much, but the rate at which your real dollars are increasing has substantially improved. In any event, it’s much easier to visualise this exponential effect if we use bigger numbers, so let’s bump them up. Imagine Andrew invested $1,000,000 in the share market and he was lucky enough to return 10% every year for 25 years.
We can see from the table above (I’ve shortened it so that unlike a pair of birkenstock sandals, it’s easy on the eyes) that between Year 0 and Year 1, Andrew made $100,000. But between Year 24 and Year 25, he’s made $984,973. Because Andrew’s returns are compounded, the longer his money is invested, the more he can expect to return per year as each of those years pass. Again, we can more easily observe this exponential effect if we plot the numbers on a graph.
If you take away nothing else from this article, take away this – investing is important and investing early is paramount. In this example, if you had missed just a single year and decided to invest for 24 years instead of 25, you would have lost $984,973 in value. It’s so difficult to see how important this is when the value is realised 25 years from now but please understand that there is significant value in taking action early.
Now that’s all well and good, but most of us don’t have $1,000,000 to invest for 25 years. This is a fair comment (admittedly a bit narcissistic of me to praise my own comments), but it shouldn’t discourage you from making your money work for you. Many of us do have some spare cash lying around that could be invested rather than stashed under the mattress or sitting in a bank account earning next to nothing after inflation (thanks for that RBA).
Throughout your lifetime, you will accrue disposable income (income you can use to buy things you want like smashed avo or birkenstocks (please don’t buy birkenstocks)). I’m not going to tell you how you should deal with your disposable income (except for the birkenstocks comment – really, please don’t). As always, I simply mean to set out your options for you.
The opposite is also true
Compound interest can also hurt you, a lot. Compound interest is the reason why someone can buy their home for $600,000 and end up paying more than the value of their loan in interest repayments over the life of that loan. It’s the reason you’re always being urged to shop around for the best possible rate you can get on your mortgage. The table below compares how much interest you would pay over the life of your 30 year, $600,000 loan if you’re charged between 3 and 6 percent interest. The table assumes fees payable on the loan are $260 per year ($10 per fortnight) and that repayments are made fortnightly.
|Interest rate||Interest paid over 30 years ($)|
A mere 3% difference in interest rates over a 30 year period means you’re making more than double the interest payments. Once upon a time, your choices were limited to a country’s largest lenders. Competition was low and banks could charge high interest rates. Now, there are a plethora of bank and non-bank lenders in the market and you certainly don’t have to prove your loyalty to the bank you’ve always banked with.
Compound interest is the reason why people with credit card debts have such difficulty paying off those debts and the reason why your superannuation balance never seems to reflect nearly what your return on investments were (yes, even the industry super funds are hurting you – more on that in a later article).
Learn it. Memorise it. Apply it. I repeat – compound interest is the single most important concept you will ever learn.