Last week, by way of a simple example, the power of compound interest was demonstrated. This article emphasizes how important it is for you to have this superb financial tool working for you in setting and achieving your financial goals.
Compound inteest is a silent, super-effective worker in making your money work for you. The higher the interest rate and the longer the period, the more compound interest will generate dividends for you.
A simple mathematical formula helps to define the results that compound interest will provide over time. It is called the rule of 72. If you divide the compound interest rate into 72, the result is the number of years it will take for your initial investment to double in value. For example, six goes into 72 12 times, so it will take 12 years for $5 000 to become $10 000 at a compound interest rate of six per cent.
Here is a practical example, represented in part by the table above:
The first column set out the years of investing. Column 2 sets out the amount invested each year. Column 3 sets out the amount accumulated on a 5 per cent compound interest basis.
This table presents the result of saving and investing $400 per month on the birth of your child for the first eight years of the child’s life. At the end of year (EOY) one, you would have save 12 X $400 = $4 800. By EOY two you would have earned five per cent interest on the first years $4 800 and added another $4 800.
Repeating this process, compound interest accumulates $45 835.72 by the EOY eight. If this sum is left to grow at the five per cent compound rate thereafter without adding any additional money, by the EOY 10, the accumulated amount would be $50 533.88.
Then, the effect of time alone (no additional funds) will generate a fund balance of $75 000 when the child is 18, and may be ready to go into university; $105 000 at age 25 when that child may acquiring his own home; $278 000 at age 45 when that child may be needing to send his child to university; and $739 595 at that child’s retirement age of 65.
This example shows how simple savings invested over a long period of time at a reasonably good interest rate can serve to secure the future.
You can also test the rule of 72. In this case five goes into 72 just over 14 times – let’s say 15 times. So the investment of roughly $50 534 at the EOY ten should be double 15 years later at age 25. This $105 000 investment at age 25 will also double again in another 15 years. By age 40, the $50 334 investment would have become $218 404. This investment at the five per cent rate will keep doubling itself every 15 years.
So if the interest rate was higher, say eight per cent, the investment will keep on doubling in value every nine years. Again, this example is to help you understand and appreciate the impact of the interest rate and time in using the efficient compound interest system in growing your investments.
In the first instance you may have been thinking of securing your child’s future but to the extent that that child never draws on the fund you will have a worthy pension fund by just accumulating a relatively small fund but leaving it to compound over an extended period.
• Louise Fairsave is a personal financial management advisor, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances.
