What if you could invest NZ$5,000 and in 10 years, it might be worth more than NZ$6,000?
A really useful concept behind this is one that physicist Albert Einstein once called the “eighth wonder of the world”. It’s called ‘compound interest’.
We all know that savings earn interest. Well, if you reinvest that interest, the savings are ‘compounded’.
Here’s how it works:
• You start with NZ$5,000 and after a year at 3 per cent interest, you have NZ$5,108 in the account.
• The next year, the interest payment is calculated on the NZ$5,108 and added to the total. Now your pot of money has grown to NZ$5,218 after 12 months.
• Every year, your investment earns even more interest than it did in the past, supercharging those returns.
• After 10 years, you have NZ$6,191 in the bank and, eventually, it will double in value.
I’ve used a current notice saver account rate to do this calculation, paying 3 per cent on balances of NZ$1 and above at the time of writing.
(To make it a real-life calculation, I’ve also deducted tax at the highest rate of 28 per cent for this type of investment.)
Investing in Fruit Bursts
Millennial Simon Brown, who is the chief operating officer of Banqer, an app designed to educate young people about money, says compound interest is difficult to explain with words or whiteboards alone.
So, he uses Pascall Fruit Burst lollies in classrooms, because it’s much more effective at getting the message across
The children are given 10 Fruit Bursts each. If they come back with all 10 sweets after 15 minutes, which represents a year, they receive 10 per cent interest.
That means they walk away with an extra Fruit Burst. Then after another 15 minutes they receive interest on their 11 Fruit Bursts, which Brown rounds up generously.
Supercharging funds and KiwiSaver
Compounding may look attractive with bank accounts or Fruit Bursts, but it’s even better for investments such as KiwiSaver or managed funds.
These offer higher returns than savings accounts, meaning the money multiplies faster.
With KiwiSaver, thanks to compounding, the government bonus of NZ$521, and employer contributions, many KiwiSaver investors have doubled the sum of their own money they’ve invested over the past 11 years.
Keep on your toes
For compounding to work to your full advantage, you do need to keep a close eye on the interest rate your bank is paying you, or what your fund is earning.
Banks advertise juicy interest rates, but then drop them when you’re not looking. Review your investments often to make you’re getting the best returns for your situation.
There’s a sting in the tail of compounding – it also works in the opposite direction. If you’ve borrowed money, compound interest will be adding to your debt at an accelerating rate.
If you’re borrowing and don’t pay the interest or only make the minimum payments, your debt can grow just as fast as your savings compounds. Never let that happen to you.
How long to double my money?
If you want to know how quickly your money will double, there’s a handy calculation called the ‘Rule of 72’.
Divide the number 72 by the interest rate you’re earning, to work out roughly how many years it will take to double.
Let’s say your KiwiSaver balance is returning 8 per cent per year. Divide 72 by 8 and you get nine years. This doesn’t include tax and inflation. It’s just a guide.
Finally, the more investments you have compounding, the better. Regular savings and investments that aren’t touched over a long time-frame will help you get through many years of retirement in financial comfort.
Published August 2018
Story by Diana Clement
We aim to make things about money easy to understand. To help us make this article reader friendly, we used The Write Plain Language Standard.
All content is correct at time of publication date. This article is general in nature only and has not taken into account any particular person’s objectives or circumstances. We recommend you speak with a financial adviser.