In the world of investing, when something sounds too good to be true, it usually is.
‘Compound interest’ is the exception to this rule. Although you could be excused for being sceptical when you see it described as everything from ‘magic’ to ‘a miracle’ to the ‘eighth wonder of the world’.
So what is this magical, mystical thing, and how can you get it?
Interest on interest
Compound interest occurs when the interest you earn on money you invest gets added on to your overall investment. This combined sum then earns even more interest the next time it’s calculated, which is then added back on to the combined sum, which grows even larger and therefore earns more interest… and so on and so on…in other words it’s ‘compounding’.
It’s been compared to a snowball, which starts off small then gets bigger and bigger as it rolls down a hill, gathering even more snow as it goes.
And as with this snowball effect, the longer you leave your money, the greater the compound interest you earn. This is why it’s a real benefit for long-term savings vehicles like KiwiSaver. Along with employee and voluntary contributions, and the contributions from your employer and government, compound interest is one of the main reasons your account can grow so well compared to just saving.
But I don’t get an ‘interest rate’ on my KiwiSaver account – I get ‘returns’?
With KiwiSaver, compound interest is not quite the correct term, as you don’t earn interest as such. ‘Compound returns’ is probably a better description – but the principle remains the same – i.e. any returns earned by your KiwiSaver account are added back into your account to earn further returns in the future.
And the earlier you start saving the bigger your investment can grow. Decades of paying into an investment like KiwiSaver can build a pretty impressive snowball.
What about other investments – do they have compound interest?
Not all ‘investments’ offer the benefit of compound interest/returns. A term deposit savings account, for example, typically pays interest at the end of the term rather than monthly or quarterly during the term, so you miss out on the benefit of compounding interest. This is one of the key differences between ‘saving’ and ‘investing’. Investments offer the potential for greater growth over time. However, savings products definitely have their place as well.
If you buy shares in a company directly (rather than through a managed fund like KiwiSaver) you can obtain a similar effect to compound interest by allowing any dividends you earn to be used to buy additional shares rather than receiving them as cash, which will then allow you to earn more dividends, and own more shares.
The darker side of compounding interest…
Compound interest is great when you’re investing but not so good when you owe money. It’s the reason things like credit card debt, mortgages, and fines can add up to so much over time.
One way to reduce the effect of compound interest on your debt, is to always pay your lender more than the minimum repayment amount, to reduce the size of your principal (the initial amount you borrowed) which will then reduce the term of the debt and therefore the total interest you pay.
Even paying just a bit more than the required repayment on your mortgage, for example, can take years, and thousands of dollars, off your loan.
Or in the case of a credit card, aim to pay the balance off in full at the end of each month to avoid (negative) compounding interest altogether.