Compound Interest  

 

 

 

 

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Compound Interest  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The Elevation Group

 

The Power of Compound Interest

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Compound interest is a fundamental component in the laws of money.

If people were taught it at school as part of a money management unit, I doubt that 95% of retirees would require the govt. pension for support as they do today. If all who learnt it applied it, far more than the current 5% of people would attain financial independence.


Compounding interest simply refers to the fact that the interest you receive will be calculated not only on the principal amount that you invested, but also upon prior interest amounts added to your investment.


Let's look at an example. Back at the start of 1994, David invested $10,000 into a 15yr fixed interest fund paying 15% per annum. He has the choice of either having the $1500 annual interest income paid into his savings account, or of re-investing it back into the fund.


Here's how much money he would make when his fund matures at the end of 2008 given both scenarios:

 

 

Interest Paid Out Option

Interest Re-Invested Option

End Year

Amount Invested

Plus Interest Paid Out

Amount Invested

Plus Interest Re-Invested

1994

$10,000

$1,500

$10,000

$1,500

1995

$10,000

$1,500

$11,500

$1,725

1996

$10,000

$1,500

$13,225

$1984

1997

$10,000

$1,500

$15,209

$2281

1998

$10,000

$1,500

$17,490

$2624

1999

$10,000

$1,500

$20,114

$3017

2000

$10,000

$1,500

$23,131

$3470

2001

$10,000

$1,500

$26,600

$3990

2002

$10,000

$1,500

$30,590

$4589

2003

$10,000

$1,500

$35,179

$5277

2004

$10,000

$1,500

$40,456

$6068

2005

$10,000

$1,500

$46,524

$6979

2006

$10,000

$1,500

$53,503

$8025

2007

$10,000

$1,500

$61,528

$9229

2008

$10,000

$1,500

$70,757

$10,614

Total Interest Credited:

$22,500

 

$71,371


Interest Paid Out Option

Total Return upon maturity (end 2008)

Interest Re-Invested Option

Total Return upon maturity (end 2008)

Initial Amount Invested

$10,000

Initial Amount Invested

$10,000

Interest Credited

$22,500

Interest Credited

$71,371

Total Return

$32,500

Total Return

$81,371


Simply by re-investing his interest, and making use of the power of compounding, David has come out ahead by $48,871. Put another way, if he had chosen to have his interest paid out to him, he would have tripled his initial investment after 15 yrs. By reinvesting his income, he was able to multiply it 8 times!!


As we can see, the longer the period of time, the greater the benefit. Below is the comparative table for David had he invested his funds just 5 more years, into a 20 yr fund:

 

Interest Paid Out Option

Total Return upon maturity - 20yr Fund

Interest Re-Invested Option

Total Return upon maturity - 20yr Fund

Initial Amount Invested

$10,000

Initial Amount Invested

$10,000

Interest Credited

$30,000

Interest Credited

$153,665

Total Return

$40,000

Total Return

$163,665


The difference now, given just 5 extra years, is a staggering $123,665. In other words, David has multiplied his initial investment 16 times by re-investing his interest income, as opposed to only 4 times by electing to have it paid back to him.


And herein lies the key and power to compound interest. Anyone in our prosperous nation can become financially free with sufficient time and given 3 keys:

  1. That you learn to live on less than you earn, and invest what disposable income you have (George S. Clason in his book The Richest Man in Babylon suggests you should set aside and invest a minimum of 10% of your income)

  2. That you invest at a reasonably good interest rate (i.e. well above the rate of inflation)

  3. That you start as soon as possible to put time on your side

 

If a 20yr old starts investing just $100 per month ($23 p/w) at a return of 15% pa, by the time they retire at age 60 they will have accumulated a sum of $2,455,144.63.


If you're a 20yr old reading this, I urge you to start doing this now. Don't put it off the key to compounding is time. If you wait until you're 30 to start doing this, you'll only have $599,948.30 by age 60 instead of
$2,455,144.63.


If you're 40 or 50 and you're reading this, don't be discouraged. You're obviously not going to be able to derive the same benefit from compounding compared to a 20yr old, but start now anyway the sooner you start, the better off you'll be.


The final question you may be asking is: where can I get a 15% return in these low interest rate times? Well obviously, you won't get it by putting your money into a term deposit at the bank. It's not my place to provide financial advice - you should speak to a certified financial planner for this. But I should say that 15% is not too difficult to achieve even with limited financial know how.

The Australian accumulated All Ordinaries index has historically achieved close to this. Although the past cannot be taken as an indication of the future, an equities index fund could be considered, such as an ASX300 accumulation fund. This type of fund will give you a little piece of all of the top 300 shares on the Australian market, minimising your exposure to a downturn by any one company or market sector.


Alternatively, it's quite easy to find Australian blue chip shares that are paying 5% fully franked dividends at the moment this equates to 7% or so with franking credits thrown in. Add to that capital growth of another 7% or so per annum, and you'll be well on your way to achieving a 15% return with dividend reinvestment.


For more sophisticated investors, it's not too difficult to achieve even higher returns (such as, for example, selling call options over a portfolio of blue-chip shares), but this will require some time and effort to learn and is an active form of investing as opposed to passive.


Finally, once you've chosen your passive investment fund and have determined the regular monthly amount you will be investing, put it on auto-pilot. Set-up a periodical payment so that the amount is taken from your bank account automatically every month and invested into your fund. Try to start with 10% of your income as a regular investment.


Stay disciplined and don't dip into your funds for any reason short of major crisis. Your funds should only be accessed once you've accumulated a large enough sum that you no longer need to work.


Start today... and best wishes on your journey to becoming Financially Free smile

 

 

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This calculator comprises two worksheets: one for lump sum compounding, and another for regular payment compounding. It enables you to enter your own variables as to the amount of your lump sum / regular contribution, the interest rate at which you wish to compound your money, and it will provide you with results going out over 40 years.

 

 

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