You don’t need to earn a massive salary to reach your financial and retirement goals. You need one simple thing: time. Yes, thanks to the magic that is compound interest, anyone can – like Benni – build wealth if they start saving timeously.
What is compound interest?
Compound interest allows you to invest a sum of money today, and have it grow to a much larger amount over time. It’s a bit like the snowball effect, and is sometimes described as “interest on interest”.
How is compound interest calculated?
With compound interest, the interest for the first period is calculated and then added to the initial amount. The interest for the second period is calculated on the larger amount, and then added to it. And so forth and so forth. Not making any sense? Look at this example.
Say you deposit R1 000 into an account that offers 8% interest per year, and don’t touch it for a whole year. At the end of year one, your account balance will be R1 080 – which is the initial R1 000 plus R80 (or 8%) interest. At the end of year two, your account balance will be R1 166.40 – which is R1 080 plus R86.40 (or 8%) interest. It’s not hard to see how this balance will get substantially bigger over the years.
Compound interest in action: How Tanya saved more than Tony
Tanya and Tony are twins, and clients of the same bank, with an 8% interest rate, that is compounded monthly.
Tanya starts saving at 25. She saves R500 a month for 10 years, and then stops making contributions. Tony only starts saving at 35. He saves R500 a month, until he retires at 65.
When they retire, Tanya has saved R1 006 993 and Tony R750 147.59. How is that possible? Compound interest… and time! It’s magic.
You can learn more about the complexities of compound interest here.