The power of compound interest

Compound interest is the eighth wonder of the world.

He who understands it, earns it.

He who doesn’t, pays it.

Albert Einstein isn’t the only bright spark to recognise the power of compound interest.

Legendary investor Warren Buffett called his biography The Snowball in reference to the snowball effect. He started investing as a teen and that snowball is still rolling and growing exponentially. Now in his 90s, after a lifetime of buying quality investments and holding them for the long term, his net worth is over US$116 billion.

By understanding the basic principle of compound interest, especially early in your working life, you too can grow modest, regular savings into a substantial nest egg. You may not end up on the rich list, but you can still enjoy a comfortable standard of living in retirement.

That’s the simple concept behind superannuation, but compound interest is not simple.

Compound interest vs simple interest

When you are earning compound interest on an investment, it means you not only receive interest on the principal invested, but you also receive interest on your interest plus principal. That’s why compound interest is often referred to as ‘interest on interest’ and it will grow a lump sum faster than simple interest.

We look at compound interest and how it applies to your super in the future, but first, it’s important to understand how compound interest differs from simple interest.

Simple interest is generally paid in one hit at the end of a specified period. Term deposits are a good example. Say you invest $10,000 in a one-year term deposit at 5% interest; at the end of the term, you receive $500 plus your initial investment of $10,000 for a total of $10,500.