Thu 24 May, 2018
How to Turn Hundreds into Thousands: The Power of Compound Interest
Fancy turning $1,000 into $10,000 using smart cash investing? If you’re just starting out in the investment game and you’re planning your financial future, compound interest is one of the first concepts you should get your head around. Understanding how interest works and how you can use it to make long term financial changes could be the key to a solid future.
What is Compound Interest?
At its core, interest is earned on income held in the bank. Compound interest refers to that extra interest you earn on that interest, providing it’s reinvested back into your savings.
Nutty example: if you invest $1000 into a savings account with a 3% interest rate, you’ll earn $30 of interest that year. If you leave that $30 in the account, the following year you’ll earn 3% on $1030 – meaning that year you’ll earn $30.90 in year 2. That might not sound like much, but simply leaving that cash in the savings account for 50 years would leave you with more than four times your initial investment. You’d be left with a balance of $4383.91!
Get in it For The Long Haul
Compound interest is all about long-term, low risk investments. There may be other investment strategies that will yield faster and bigger returns, but investing cash on a compound interest strategy is very easy to automate – it’s essentially set and forget.
Get on board with incremental investing early, and you could easily yourself enough for a wedding, honeymoon, helping your kids go to university, or even fund some of your retirement. It’s all about setting achievable goals and being consistent. Don’t go all in and promise to save half of your income each month if that’s not realistic. Getting into the habit of saving even 5% of your income at an early age – and remembering to maintain or increase that figure as your salary grows – can make much more of an impact on your financial stability.
Let’s take a look at three ways you can use compound interest at any age.
Compound interest in your 20s
In your 20s, you’re looking at a solid 40-45 years of full time work ahead of you. At this age, you have the opportunity to get savvy with saving rather than spending every last cent you earn on avocado on toast and tickets to indie festivals. Simply putting away $10 from every pay check or $20 a month can make all the difference. Start early and you may find yourself with a hefty sum tucked away for a big life event.
Case study: Sarah starts working at a retail store when she is 18. She puts away $20 each month into a savings account with an interest rate of 3%, and continues doing so until she gets a full time job when she is 23. At this point she realises she can afford to save more than $20, and ups her contribution to $100 per month. By the time Sarah is 33, she’s getting married. She has had 5 years of saving $20 per month, and 10 years of saving $100. The interest rate remained the same*. Her balance at age 33 is now $15,719.29. Of this, almost $2,500 was from compound interest.
*same interest rate is only for illustrative purposes only. Interest rates fluctuate and are unlikely to remain constant for years at a time.
Compound interest in your 30s
Making a savings plan in your 30s is likely with the aim of securing your financial future a little later in life. At this age, you might be able to contribute a little more than just $20 a month, and may settle on a percentage of your salary. If you’ve got young children, you might be looking at helping them buy their first property in 20 years time. Start now, and that needn’t be such a burden.
Rob earns $69,000 in his job as a graphic designer. He decides to put 5% of his take-home income away into an ‘in 20 years’ fund with a 5% interest rate, meaning he stashes $2,682.40 per year. Rob then gets promoted when he is 36 – and his new job comes with a tidy new salary of $90,000. Sticking to his 5% plan, Rob is now putting away $3,363.40 per year. So, in 20 years, Rob had 6 years of saving $2,682.40 and 13 years of saving $3,363.40. His balance at the end of the 20 year period is $96,505.45, of which $34,046.13 is interest!
Compound interest in your 40s
By the time you reach 40, your mind may be beginning to wander towards retirement. While the official retirement age in Australia is currently 65.5*, some people wish to take an earlier retirement, or cut back their working hours and supplement their income with savings.
*correct at May 2018
Greg is 42. He fancies himself as a semi-retired 55 year old, and would like to spend his days working part time and playing golf. He has a tidy superannuation pot put aside for his full retirement from his job with the Department of Education, but would like to stash some extra cash to take an early semi-retirement. Greg earns $140,000 per year in his job as a Principal, meaning he takes home $8,143.67 per month. Having recently been promoted from Assistant Principal to Principal, he decides to stash 15% of his new salary in a savings account with a rate of 4%. This means he’s saving $1,221.55 per month. Over the 13 years until he turns 55, he saves a total of $190,561.80, and pockets $58,413.45 in interest. His balance is now $248,975.25!
Get saving! The ASIC Money Smart compound interest calculator can help you explore how small, incremental savings can add up to big returns from compound interest. Start small today and see how far you could get by sticking at it.