The magic of compounding interest

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Compound interest is the eighth wonder of the world.

He who understands it, earns it.

He who doesn’t, pays it.

This quote from history’s greatest scientist Albert Einstein sums up succinctly the beauty of compound interest, which allows you to earn interest on your interest. By understanding this basic principal, especially early in your working life, it’s possible to build a superannuation balance which will provide a comfortable retirement income.

How does compound interest work?

Compound interest is the interest calculated from an initial sum of money which is then added to the total which increases each time that interest payment is paid out. This is why compound interest is often referred to as “interest on interest” and it will grow a lump sum faster than simple interest.

Simple interest is different to compound interest in that usually the interest is paid in one hit at the end of a specified period. Term deposits are a good example of this.

Most people will have some sort of online savings account and this is a good example of how compound interest works. Every month, the bank or financial institution pays you interest on the balance, which boosts the amount in the account. If you add more savings to this, then even more interest is added each and every month.

We’ll show how this also applies to super and retirement savings a little further down, but let’s take a look at a hypothetical savings account first, with and without compound interest.

If you invested $5,000 for 5 years at 5% per year, with interest paid at the end of the term, you would earn $1,250 in simple interest after 5 years, or $250 for each year. This would give you a total of $6,250 after 5 years.

If you invested $5,000 for 5 years at 5%, with interest paid annually, you would earn $1,381 in compound interest after 5 years, giving you a total of $6,381.

Returns would be higher because you’d earn interest on the interest each year. It may not sound like a huge difference, but that is a 10% higher balance in just 5 years.

It’s also important to note that the amount of compound interest accrued will be affected not just by the amount of interest paid out, but also the frequency of the payments. So, if 5% interest is accrued monthly on $5,000, the balance will be higher than if 5% interest is accrued annually.

This example shows how compound interest returns grow exponentially over time and how powerful it can be as part of an investment strategy., and the longer you have to compound, the better off you will be.

The power of compound interest for your super

This same principal applies to your superannuation, but there is even more power in the magic due to the long time-frame super is invested over.

By contributing to super, you become an investor in a mix of assets such as shares, infrastructure, cash and term deposits which all yield varying rates of return. By investing over a long time-frame, when you retire and access your super you should expect to have much more than simply what you contributed.

While there will be negative years there should be considerably more positive years. Over time your balance steadily accumulates as you get greater returns primarily because of an ever-increasing capital. While your contributions and rate of return may stay steady, the interest on the interest (or returns on the returns) has the mighty compounding effect.

To illustrate this, below is a simple example showing someone on a $50,000 income contributing their basic superannuation contributions from their employer (9.5% of $50,000 = $4,750 per year).

To make the concept of compounding easier to understand we only add the contributions at the end of the year, so in the first year there is no interest earned. We have kept the contributions and returns (5% per year) static, but of course that would not happen in the real world. Wages and returns can go up and down and the superannuation guarantee is also due to rise beyond 9.5% in the coming years.

For this demonstration we are also putting aside the impact of inflation and the concept of “today’s dollars”.

After 40 years, $190,000 has been adding to super in contributions, but more than twice that ($383,799) has been added in compounded returns (or compound interest).

To further illustrate the importance of time to the equation, we can also estimate the difference that making additional contributions makes at different starting points.

1. If we add an additional $500 in contributions per year across the full 40 year time period ($20,000 in total), the end balance would be $634,199.
2. If we add an additional $1,000 in contributions per year across the last 20 year time period (again $20,000 in total), the end balance would be $606,865.

So while it’s the same amount of contributions, and the same time period, contributing earlier makes a 4.5% better overall return.

Even modest contributions to super early on in your career can make a big difference to money you end up with in retirement. Naturally returns will vary each year, but this is why they call it the Magic of Compound Returns.