The magic of compound interest and other financial concepts
There’s more to life than money, but understanding some basic concepts helps lay the foundations for a lifetime of learning that helps you better manage your financial affairs.
The difference between people of wealth and those who aren’t can largely be explained by differences in the way they think. This, in turn, leads to differences in habits and skills.
The aim of this occasional series of posts is to provide insights to help people feel more empowered to seek advice and ask the right questions. Remember, the quality of the questions you ask determines the quality of the answers you receive.
The ‘magic’ of compound interest
I’ve been privileged to have attended some of the best finance and superannuation conferences in Australia over the past 45 years. One speaker stands out as a legend—Dr Don Stammers. Don is a highly regarded economist who writes for several media groups, commentates on the Federal Budget, and is (or has been) a board member of many of Australia’s leading financial institutions.
In almost every speech, Don weaves into his presentation this question: ‘Have I told you about the magic of compound interest?’
Compound interest is the investment return investors earn when they invest in an interest-bearing bank account, term deposit, and online savings accounts.
Compound interest refers to earning interest on the interest already credited to your account. The key is earning interest on interest. A simple example shows the difference:
Compare a three-year term deposit, which pays the interest at the end of three years, with a compound interest account that credits the interest annually.
|Amount invested||Interest 3%||Result after 3 years|
|Normal three-year term deposit||$100,000.00||$9,000.00||$109,000.00|
|Compound interest term deposit||$100,000.00||$9,272.70||$109,272.70|
But there’s more magic if you ‘supercharge’ your savings. Read on.
The impact of making regular deposits.
ASIC (the Australian Securities & Investments Commission) has a useful calculator here.
This calculator can help you work out the difference between saving now and saving later. It will tell you how much money you’ll have if you invest a regular amount (through superannuation, perhaps) and how compounding interest increases your savings interest.
Regular savings plans can be set up for interest-bearing accounts, superannuation and managed funds. The longer the time period involved, the better the results will be.
As a guide, a savings account that starts with a $1,000 deposit and monthly contributions of $100, with an assumed annual average earning rate of 5% would grow as follows:
- Investment after 10 years $17,175.00
- Investment after 20 years $43,816.00
- Investment after 30 years $87,694.00
Disclaimer: The calculations shown above don’t take into account any taxation impacts. Readers should be aware that interest rates and the earning rates on superannuation and managed funds vary over time.
Supercharge your savings
If you can increase the frequency of your regular contributions, the results improve. For instance, if, instead of monthly, you make you make fortnightly contributions of $50 the result after 10 years would be $18,469.00
Compare this number to the 10-year result above ($17,175.00). This approach suits people who are paid fortnightly—and the increase is quite dramatic.
Compound interest in reverse
While compound interest works for those who are saving money, a similarly powerful effect applies for those people who want to reduce their mortgage quickly. Making fortnightly loan repayments will significantly reduce the term of a mortgage.
Price Inflation works in similar ways because over time an inflation factor, when applied to wages, pushes up your take-home pay. However, when an inflation factor is applied to the value of your house, the price rises.
Why Capital is more important than Income
It’s important to make a distinction between ‘income’ and ‘capital’. Income refers to wages and salaries, interest earned on savings, investment returns from rental properties and dividends from investing in shares.
In simple terms, these are items that may appear on a taxpayer’s annual tax return. The tax rates that apply to taxable income are progressive, meaning that the more you earn, the greater the average rate of tax will be.
Capital refers to the items that could be sold at a profit by a taxpayer. The items could include investments held for more than one year, a rental property or holiday house, shares and managed funds, and a business or farm.
Taxation law distinguishes between the profit made when a Capital Gains Tax event occurs (meaning a sale has occurred) and ordinary taxable income. Individual taxpayers who sell an investment at a profit, are only taxed on 50% of the profit.
It’s wise to build into your investment plans items that will one day be sold at a profit. Smart investors place more emphasis on capital gains than generating a regular income.
Investors who make Capital Gains can also select when to sell, which may involve taxation considerations.
While this post has focused on details of the Australian system, the principles are universal.
Owen Weeks is director and authorised representative of Lifestyle Matters Pty Ltd and a Registered Tax Agent. He is a Fellow of the Financial Planning Association, a Fellow of the Institute of Professional Accountants, and an Honorary Fellow of the Association of Superannuation Funds of Australia. He is also the co-author of Retire Bizzi and Where to Retire in Australia.
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