The Power of Compounding Interest

Compounding is when the interest on a sum of money, either a deposit or loan, is added to the original amount so that the interest earned also earns interest. Albert Einstein’s popular quote; ‘Compound interest is the eighth wonder of the world. Those who understand it, earn it... those who don’t, pay it’ highlights the impact compounding can have over time, and cautions that it can work either for or against you.

“When you invest in unit trusts, time allows your invested money to grow and compounding makes your money work harder for you,” says Wanita Isaacs, investor education manager at Allan Gray, an independent African asset manager. “Given a long enough period to work, compounding can dramatically multiply the value of your investment so that less of your total investment will be from your contributions and more from investment growth.”

While compounding can be seen as the magic ingredient for successful investing, the same mechanism works against you when you borrow money, for example, through credit cards or a personal loan.

Isaacs explains that the amount you owe earns interest over time and through the effect of compounding, the cost of credit can work out to substantially more than the cash amount you borrowed, depending on the interest you are charged and the length of time you will be paying the loan back.

How does compounding actually work?

In summary, the impact compounding will have on either an investment or a loan depends on:

·         The amount invested or borrowed

·         The time period

·         The growth rate (the rate of return on an investment or the interest charged on a loan)

·         The compounding frequency (the more frequently interest is added to the original amount, the greater the impact of compounding. For example, daily compounding means that you earn returns today on the amount you invested, as well as the returns you earned yesterday on the returns you earned the day before. This has a greater impact than compounding monthly, which has a greater impact than compounding annually.)

The table below uses the example of an investment of US$10 000 and annual compounding to illustrate how compounding works. “After 20 years, your US$10 000 investment will grow to US$67 275 – a gain of US$57 275,” says Isaacs, adding that if your returns had not been added to the original amount and left to grow; if you had spent them instead, the total gain from your investment would only be US$20 000. “Since you would have spent this US$20 000, you would only have the original US$10 000 still invested.”

Table 1: How compounding works

	Amount of your investment	Return rate	Total amount with return earned
Year one	US$10 000	10% annually = US$1 000	US$11 000
Year two	US$11 000	10% annually = US$1 100	US$12 100
Year three	US$12 100	10% annually =US$1 210	US$13 310

How do you ensure compounding works for you?

To benefit from compounding, you first have to start saving and the sooner you start the better. “You also have to be disciplined and not spend the money your investment makes before you reach your savings goal,” adds Isaacs.

The cliché that good things come to those who wait is especially true when it comes to compounding. Both the decision to invest and the decision whether or not to use credit are essentially choices between instant and delayed gratification. “If you choose to use credit you will have to pay for the benefit of instant gratification whereas, if you choose to save, you will be rewarded for delaying gratification,” Isaacs concludes.

Thandi joined Allan Gray in 2008. She is a senior member of the distribution team having previously worked in legal and compliance and marketing in the financial services sector. Thandi completed her Masters of Business Law at the University of KwaZulu-Natal and is an admitted attorney.