First up, a famous quote credited to a man better known for his general theory of relativity, Albert Einstein:
“Compound Interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t … pays it.”
We all hear about compounding interest and how it is interest earned upon interest, but do we really understand the impact that it can have on our savings? You think you might know, so let us test you with an example.
1) Bob is born today. His dad saves R 1,000 today, and will save another R 1,000 at the start of next year. The total investment would be R 2,000.
2) Faye is 21 years old and just started her first job. She will save R 2,000 every year until age 30. The total investment would be R 20,000.
The similarities between Bob and Faye is that they would both like to retire at age 55 and both will be earning an aggressive 13% per year in their respective investments. The question is, who will have the most money saved up at age 55? It’s obvious right? Wrong.
And the winner is………Bob! He will end up with R 1,768,862.17 over Faye’s R 883,798.45, even though her investment amount was 10 times larger than Bob’s. Bob has 2 times the money at retirement. That is seriously significant, and fully illustrates the power of compounding interest. If you are more graphically inclined, the graph below should put things into perspective:
The funny thing is, once Faye stops contributing at age 30 she already has half the value to retire with than what Bob has. This difference stays constant, and she gets left behind from the moment she stops contributing.
The next question would then be: until which age would she need to invest R 2,000 per year in order to be on equal footing with Bob? Any guesses? The answer is NEVER. Because she started investing 21 years after Bob, no matter how long she invests R 2,000 per year, she will never have as much money as Bob to retire with.
In actual fact, she would need to contribute R 3,000 per year from age 21 to age 43 (a total investment of R 69,000) to be on the same level as Bob who only invested R 2,000. Scary stuff.
We hope this simple explanation of compounding interest has cleared up the eighth wonder of the world for you. If you would like to unlock this wonder and make your investments work for you, get in touch!
