Compound returns explained: The eighth wonder of the investing world


Jason Prowd  |  19 July 2018  |  3 mins read

Key Points:
  • Compounding is awesome and can help accelerate your wealth. Here, we explain how.
  • Given that bank interest rates remain at historic lows, it’s worth considering if you’re best served via cash in the bank or investing instead.
  • It’s never too late to begin saving and taking advantage of compound interest.

If I had my way, compound interest would be one of the earliest lessons kids learn at school. It’s one of the most fundamental building blocks of financial literacy – and the younger you are when you learn about it, the more you can benefit from it.

Let me explain.

First up: what’s an interest rate?

Interest is the reward you get for lending someone your money. Your money is valuable, and you could use it to go on a holiday or head to the footy. If you’re going to lend it to someone else – and forgo being able to use it straight away –  you deserve to be rewarded.

We often hear about interest rates being high or low – the Reserve Bank of Australia sets its official cash rate monthly (that’s the rate of interest the RBA charges on overnight loans[1] to commercial banks like the ones you and I use). The RBA’s rate trickles down to the interest rates that banks set for consumers, whether that’s the amount you pay the bank to borrow their money, or the amount they pay you to keep your money with them.

When interest rates are low, as they have been in Australia for some time[2], most people celebrate because it means cheap credit and more affordable mortgage rates. But interest rates cut two ways, and for those of us who like to save rather than borrow, low interest can mean paltry returns if you’re stashing your money in the bank.

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What’s the deal with compounding?

Compounding is the interest you earn on your savings, plus on your prior interest. It’s awesome.

Let’s work through an example to show you its power.

First, imagine you’ve got $10,000 and you lend it to your brother for five years. He agrees to pay 5% interest each year paid at the end of the term. That’s called simple interest. You’d end up with $12,500, see Table 1 below.

Table 1: Simple interest example

Deposit Interest Total
Year 1 $10,000 $ – $10,000
Year 2 $ – $ – $10,000
Year 3 $ – $ – $10,000
Year 4 $ – $ – $10,000
Year 5 $ – $2,500 $12,500

Now, let’s instead imagine you’ve put that $10,000 in a high-interest bank account, earning 5% interest per year, compounded monthly.

After 5 years it’d have grown into $12,834 thanks to interest you’ve been paid on your interest as you go along. That’s compounding.

Table 2: Compound interest example

Deposit Interest Total
Year 1 $10,000 $512 $10,512
Year 2 $ – $538 $11,049
Year 3 $ – $565 $11,615
Year 4 $ – $594 $12,209
Year 5 $ – $625 $12,834

The difference between the two examples is the power of compounding. Same ‘return’ but you’ve ended with more because your interest worked for you. And the longer you compound your money the bigger the impact. Over 30 years the difference widens to a massive $19,677. Yeah, compounding is awesome.

Accelerating your saving even more by investing

So far I’ve been discussing interest you can earn in terms of savings accounts. If you’re willing to bear more risk, an investment portfolio can be a good option for boosting your savings over the longer term.

Indeed, earning 7% per year on your investments, vs. 5% as per the example above, over 10 years will result in you having 21% more.

(ASIC has a simple compound interest calculator that’s very useful.)

Take advantage of compounding today

Regardless of where you’re at in your investing life, you can start getting compounding working in your favour today. Here are a few final tips:

  • Set and forget: set up a direct debit so that you can boost those compounding figures each month without thinking about it. Arrange for a percentage of your income to be diverted immediately to your savings or investment portfolio
  • Start now: while the best time to start was 10 years ago, the second-best time – assuming you’re debt-free – is today. It’s never too late to get started.

Once understood, the value of compounding your money is staggering. Get it working in your favour today and your future self with be eternally thankful.

author

Jason Prowd leads Morningstar Next: ready-made investment portfolios.


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© Morningstar Investment Management Australian Limited (‘Morningstar’) and any related bodies corporate that are involved in the document’s creation. Whilst all reasonable care has been taken to ensure the accuracy of information provided, neither Morningstar nor its third-party providers accept responsibility for any inaccuracy or for investment decisions by any person on the basis of the information included. Past performance is not a reliable indicator of future performance. Morningstar does not guarantee the performance of any investment. Any general advice has been prepared without reference to your investment objectives, financial situation or needs. You should consider the advice in light of these matters and if applicable, the relevant disclosure document before making any decision to invest. Refer to our Financial Services Guide for more information.

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