Compound Interest. MAGIC!
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We have a magician in our household and I have to hand it to my daughter, she is pretty good at performing tricks and on most occasions she has the adults fooled. She even took her act busking at our Saturday market last summer and although she is usually pretty shy around strangers, not on this day. She made a bit of money out of it that was promptly halved when she got home. Half went into her online savings account (can I hear an “oh yeah” for her 50% savings rate) and the remainder was dumped into her money tin when she got home. And there it sits today with her birthday money and other dollars she has saved along the way.
Some time back we emptied out her money tin and counted it into piles and here I got the chance to try to explain compound interest to a 9 year old. When I explained that if she added nothing else to her money tin then in one year’s time she would have exactly the same amount, she understood that. Her money was just sitting there doing nothing. And when I explained to her that the money she has in a bank account earns more money which is called interest - and then that interest in turn earns more interest - after a bit of back and forth she got that too. Her money was working for her.
Despite this understanding I was only able to take a portion of her money away and put it into the bank account. Maybe she has also developed another key strategy of “always have an emergency fund close by”. I know I’ve turned to it in an “emergency” quite a few times to pay for things!
Shhhhh, don’t tell.
So, how does interest work?
Normal interest is when you deposit $1,000 for say a one year term at 5% interest. At the end of 12 months they give you $1050 back. This is how Term Deposits at the bank work.
An example of compound interest is if you have a savings account with your bank that has $1000 in it and earns 5% interest monthly. At the end of the first month you receive $50 in interest and this is then added to your total making it $1050. At the end of the second month you receive interest on $1050 and so on….
Month 1 - $1000 + 5% = $1,050
Month 2 - $1,050 + 5% = $1,102
Month 3 - $1,102 + 5% = $1,157
Month 4 - $1,157 + 5% = $1,215
The total just keeps building as interest is added to the interest you’ve already received. It has a compounding effect and as investors WE LOVE THIS KIND OF MAGIC!
Many people I speak to who have a vague interest in the money in their life often trot out excuses of why they can’t start even just putting a tiny amount of money aside each week. They are usually saving for something that takes precedence over thinking long term; like a holiday, new shoes, a bungy jump, presents for the kids, or incredibly important modifications to a car was one I recall (think tinted windows, off road tyres and a snorkel). But I think at the heart of it is the inability to know HOW to actually start something and how the system works. They don’t think its a problem that they keep putting it off because down the track “when” they have a better job/higher income/no responsibilities they will make a start on saving and will even double their efforts to catch up.
That is a flawed strategy because the math does not work like that and here is an example of why:
Case study: Nicky and Adam compare their savings
Nicky saves $50 per week for 10 years and puts her money into a high interest savings account at 5% interest, compounding monthly. The figures below show that she ends up with $33,644 after 10 years.
Adam PUTS OFF his savings for 5 years but then saves double the amount that Nicky does, $100 a week into a high interest savings account for 5 years at 5% interest, compounded monthly. His balance ends up being only $29,469.
Nicky started her saving earlier so she got the benefit of COMPOUND INTEREST for the first 5 years. This made a big difference to her final balance. In many cases, even if you double your deposits at a later date, you may never catch up to people who start saving earlier.
I took this example from: www.moneysmart.gov.au
I was in my 30’s before I understood compound interest and that was because I saw it working in the wrong direction - my mortgage was accumulating interest each month! Whether you are nine, 22, 45 or 57 years old I propose that you just start saving something NOW, no matter how small the amount, while you dither over all the other things you might be doing with your money. The sooner you start a regular savings habit of tucking some money away the sooner that amount will build. When starting out make sure you pick an amount that you know you can stick to. Once you achieve that comfortably for a couple of months then you can think about stretching that out a little more.
I found this excellent calculator online to help you plot what saving a small (or large) amount each week will amount to: www.moneysmart.gov.au
Here I save just $20 a week for ten years. Save small amounts regularly and let your money compound.
Listening to one of The Minimalists podcasts (https://www.theminimalists.com/p060/) they pronounced the following:
“If you were to save $25,000 by the age of 25, with a 12% rate of return you will have more than $2 mill by age 65 even if you never add another $1.”
No Freaking Way! Just digest that for a moment, because surely it can’t be true? But, yes if you add it to the calculator above you will actually end up with $2,966,193. Granted a 12% return is on the generous side, but you get the idea.
This is why compound interest is so freaking awesome!
Back to my daughter, she is the perfect case study for showing how compound interest works. Each month I put a total of $130 into three different investments for her (SmartShares Index Fund FNZ, Simplicity Growth KiwiSaver Fund and an online savings account) and each month I tell her how much she has in total. Each month it is growing in excess of the $130 I have deposited on her behalf. Using her own money as an example it is good to be able to explain to her that not only is the money I deposited making money but now that money is making money too.
So, I think she has three important points covered off:
- Make a start on investing EARLY and save small amounts regularly
- Let compound interest start working from DAY ONE
- Her parents are indeed awesome
I’m estimating that by age 19 she will have over $40,000 invested if we stick to this savings course and ride the ups and downs of the market. That is an incredible achievement and one that will set her up for whatever she decides to do once she leaves home. When she starts to earn her own money (as a magician?) she will be expected to take over contributions and when she is old enough she will take control of these investments and it will be up to her how much she contributes. By understanding how compounding interest works early on in life she is in a far better position to exploit it.
“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn't… pays it.”
I could not resist this final fun example of the power of compounding interest (on steroids):
If you were given the choice of receiving $1,000,000 after 30 days OR 1 cent doubled in value every day for 30 days. Which would you choose?