Even if you don't know what it is or how it works, you've probably heard of compound interest. It's a term used by wealthy and money-savvy people – people who have been 'clever' enough to use this tactic to grow their savings by several hundred percent. But compound interest is not something that can be used only by money savvy or wealthy people. Compound interest is a simple tool that can be used by anyone to turn even modest savings into a small fortune. Here we explain how.
To understand compound interest, you first need to understand simple interest, and that's, well... simple. If you put R500 into a savings account and earned 10% interest for 2 years without reinvesting the interest you earn, you'd earn R100 rand in interest – R50 in interest at the end of the first 12 months and then another R50 at the end of the second 12 months.
Compound interest, on the other hand, occurs when you reinvest the interest you earn in the first 12 months. In this case your savings at the start of your second year would be R550, so you would not be earning 10% interest on your initial deposit but on R550 (your deposit plus the interest earned in the first year). That would give you a total R55 interest for the year and a total of R105 at the end of the second year.
An extra R5 is not much, but what would happen if you then reinvested your interest for another 10 years. You'd earn 10% on R55, then 10% on R60.50, (R55 + 10%) then 10% on R66.55 (R60.50 + 10%), then 10% on R73.20 (R66.00 + 10%) until you were earning interest on R142.40 and had accrued a total of R950 in interest. Compare this to the R500 in interest that you would have accrued if you had not reinvested your interest.
Now, imagine that you didn't stop at a single deposit, but continued to make monthly deposits for 10 years. All of a sudden, you're looking at a very different figure: a balance of R104,630, of which R44,130 is interest. The following calculations were generated by the calculator site.
To make compound interest work for you, you really need only three things, an interest rate that beats inflation, money to deposit into your account, and time.
It's important to look around for the highest possible interest rate as this will ensure that your interest outpaces inflation and gives your savings real growth. And it's equally important that you leave earned interest in your saving account, so that you earn interest on your interest. Better yet, keep making monthly deposits to build a nest egg like that in the spreadsheet above.
And then of course, you need time. The longer your money sits in a savings or investment account, the more interest it accrues. At times you'll need to practice great self-discipline to stop yourself from reaching into your savings, but in the end your hard work will be worth it.
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