Home Wealth Personal Finance How compound interest (and a little patience) can build wealth

How compound interest (and a little patience) can build wealth

If you start early and resist withdrawals, compound interest could make you rich. Just ask Warren Buffett.

Rachel Smith

Your Money contributor

Billionaire Warren Buffett is one of the world's foremost advocates of compound interest
Billionaire Warren Buffett is one of the world's foremost advocates of compound interest (image: AP/Cliff Owen)

If you save early and often – and resist the temptation to dip into your savings – compound interest can work to your advantage, financial experts say.

While this set-and-forget type of investment has the potential to reap big rewards over time, investing in the right places is important.

Here, we explore what you need to know to make it work for you.

What is compound interest?

Mention the words ‘compound interest’ to any financial expert and they’ll immediately quote Albert Einstein.

Why? Well, the theoretical physicist is famous for calling compound interest the eighth wonder of the world.

“He who understands it, earns it,” said Einstein, “And he who doesn’t, pays it.”

Compound interest, or compound returns, happen when you earn interest on your interest.

And there are many ways you can put this wonderful phenomenon into motion, says Josh Callaghan, general manager of wealth at comparison site Canstar.

“For example, say someone invests $100 and gets 10 per cent return. After year one, that investor gets $10 in interest, bringing their total to $110.

“In year two, if the investor leaves the interest in the investment, they get 10 percent on $110, which is $11, taking the total to $121. Effectively, the amount of interest earned continues to increase and over long periods of time, this is very powerful,” Callaghan says.

“In this example, the investor will double their money in a little over seven years without having to do anything.”

Accountant and financial planner Natasha Janssens from Women With Cents agrees, adding that choosing the right places for your money is also key.

“To get the best return on your money in a savings account, for instance, you need to consider the interest rate and when interest is paid,” she says.

“You should also look at any account keeping fees, as these can eat away at your compound earnings.”

Why starting early is so important

Author Noel Whittaker once referred to compounding as a ‘magic train’ that could potentially make a child a millionaire by the time they were 65 if the parents invested $2.83 a day (or $1,000 a year) into a share trust paying nine per cent interest.

So while it may be tempting to delay saving for when you have more money to throw into an account or investment, the cumulative effects of compounding are more dramatic over time – so it pays to begin as soon as you can.

“Say your choices are firstly, investing five thousand dollars a year for the next ten years,” explains Janssens.

“Or secondly, waiting until the kids are older and you’re close to retirement and then investing double. You’d be much better off to start out earlier as you’ll achieve a greater return.”

Callaghan adds that one drawback is you have to realise you’re playing a long game. Compounding isn’t a get-rich-quick investment by any means.

“It really does require savers to leave their earnings in their account to get the benefit of compounding,” he adds. “It’s delaying income for greater returns in the future.”

Choosing where to invest

One place where you should already be seeing compound interest in action is in your superannuation account.

“Compounding does most of the heavy lifting in growing your super balance,” Callaghan says.

“That’s why starting early, contributing extra amounts and choosing the right investment option up front can have significant impacts over the long-term.”

Alternatively, Callaghan says that if you want to pop your bucks in a bank account and watch it grow, you should consider three things.

“Firstly, look for the highest interest rate possible that pays into the account monthly. Second, look for an account with no fees. And finally, look to minimise the convenience of taking money out to avoid the temptation of dipping into your savings.”

Beware of banks offering ‘bonus interest’ savings accounts to motivate you to save more, adds Janssens.

“A lot of online banks, in particular, offer very competitive deals. But these often come with a honeymoon period where the bonus interest only applies for a set number of months before reverting to the standard interest rate. These accounts might also have rules, such as, minimum of deposits,” she says.

“And often we tend to forget and rarely go back to do the maths and check out what sort of interest we’re getting, or the fees we’re paying on that account – all of which can have a big impact in building your future earnings.”

Using investment bonds for compound returns

If you’re a high income earner looking to put the compounding wheels in motion, investment bonds could be a good choice.

However, Janssens says, these come with certain rules, so it’s vital you get advice before investing.

“Investment bonds sit as a separate vehicle (in your portfolio) much as the same way your super is a separate investment vehicle, and you don’t have to declare them on your tax return,” she explains.

“The tax you pay on an investment bond is capped, and if you hold onto the investment for 10 years or more, you don’t have to pay any capital gains tax when you withdraw the money – so it can be an effective route to long-term savings.”

Term deposits can also be a good way to amass compound interest, but there can be penalties and fees for early withdrawals.

Also be aware that the rate you’re paid on any accrued but unpaid interest may be re-calculated if you dip into the savings.

“They’ll often pay interest at the end of the period, but the key is to not withdraw that interest you’re earning so you don’t lose the benefit of compounding,” Janssens says.

Other ways to maximise compound returns

You shouldn’t restrict yourself into thinking that compounding only works in savings accounts or other fixed interest investments – you can get compound returns on a variety of investments, Callaghan says.

“Whether you’re getting interest from an account, dividend from shares or capital growth from shares or property, the concept of compounding works the same way.”

“Look at multi-billionaire Warren Buffett, who was quoted as saying his wealth came from a ‘combination of living in America, some lucky genes and compound interest’.”

“As an investor, think of compound returns rather than compound interest as it’s not always interest that’s compounding – it’s sometimes capital value. In saying this, reinvesting dividends, distributions and other earnings from investments is a way of boosting the compounding effect even further.”

“Effectively, the trick to compounding is maximising the value that the interest/return is calculated on.”

Using a compound interest calculator

If you’ve got a lump sum to invest (or even if you don’t) it’s always fun playing with a compound interest calculator to see just how your money might grow in the next ten, twenty or fifty years.

Just don’t take it as gospel, Callaghan warns.

“Compound interest calculators will consider an initial balance and interest rate that a saver expects to get and then projects that over a long period of time,” he explains.

“What these calculators don’t consider are changes in the interest rate over time or any extra deposits that the saver might make during that period. They’re a useful tool to play around with to understand the impact that different interest rates make and therefore, what sort of account or investment might deliver the most impact.”

Compounding for kids

Investing for your kids now – especially if they’re little – can be a great way to build compound interest and a fat nest egg for the future, whether it’s money you’ll give them on their 21st birthday or an account they’ll receive when it’s time for them to buy their first home.

“Many accounts designed for children will come with no fees and if you spend time comparing, you can get a reasonable interest rate,” says Callaghan.

“Some of these accounts will require minimum savings each month in order to get the full interest rate so parents need to be sure they understand what they can and can’t do to get the most out of it.”

“Over the long run, these accounts will generally not return as much as other investments such as shares, so once the savings have started to build up, parents may want to consider investing some of that money elsewhere.”

 

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