Compound interest means that you receive interest, not only on your initial investment, but also on the interest previously added to your investment.
- Sounds simple, but not a lot of people understand how powerful it is or how the total return grows exponentially the longer the investment is left to compound.
- Let’s take a simple example to illustrate:
- Say you had $100,000 to invest and your investment gave you a 10% annual return. You have the option to have the interest paid to you each year or re-invested.
- With the first option, at the end of 10 years, you initial investment would still be worth $100,000 and each year you would have received $10,000 in income. With the second option, the interest of $10,000 is added to the initial investment and in the second year, you earn interest on $110,000 and at the end of that year $11,000 of interest is added, and so on up to the end of the tenth year where your investment is now worth $259,374!
All you have to do is leave your investment alone and let the compounding work its magic!
Let’s take a look at what happens if you leave compounding to work for 40 years (think of your super) you can’t touch it until you reach a certain age so it has plenty of time to compound if you start early enough. Same starting point of $100,000, but this time we’ll use a conservative 5% annual return and we’ll compare taking the interest as income each year versus letting it compound: