Compounding beyond interest

Written and accurate as at: 8 August 2011

Why do some people who earn below average wages end up with much greater amounts of financial wealth than those that earn say twice as much year to year?

The answer seldom lies in what happened within a year. The answer is typically found by observing what happens year to year.

It may be simple in theory that if I save an extra say $50 each month, and stick with this habit for ten years, then I’ll be better off than if I didn’t do this.

Before we run the numbers, it can be interesting to see the effect compounding has in the world around us.

1. The growth of social media. The expanding reach of Social Media, such as Facebook, Twitter and others, reminds us of the power of compounding. In the first year, there are a defined number of people using any Social Media platform. Some of these people invite their friends to join, of which some do. As an outcome, in the second year there are users that weren’t users in the first year. Interestingly, it’s when this second group invite their friends along, that we see the power of compounding. The third raft of users may or may not know the first group! It’s at this stage that we get accelerated expansion in the number of users. View this interesting video on the growth of social media.

2. Compound interest. The theory of compound interest is taught in schools, and in some areas of life we use it well. While in others we stumble. To review the value of compounding consider this example. You invest a dollar, and after a period of time, you receive a dollar for doing so. As a result you have two dollars. Those two dollars then multiply (or double for our example) and as a result you receive two more dollars, making four. Those four dollars multiply, giving you four more for a total of eight. Then the eight dollars, receive another eight leading to 16 dollars, and so on. This outcome is the result of investing one dollar to start with, and then letting the power of compounding returns takes over.

This rate of growth would indicate a 100% return for each payment period which is unrealistic in most financial markets. Likewise, in most investment markets it’s unrealistic to expect that every year you would receive a positive return. In saying that, this example does show that significant outcomes can be obtained due to the power of compounding over time.

You can read more about compounding through our Cashflow and Compounding learning module.

So back to the question of what would be the benefit to you by saving an extra $50 per month over the next ten years?

The amount of money you would have invested yourself would be $6,000 ($50 x 12 x 10). Assuming an investment return of 6%pa after taxes and after inflation, you would end up with $8,194.

The additional $2,194, or approximately 37% on top of your $6,000 contribution, represents the benefit of compounding interest.

To expand on this example, let’s assume after the first ten years you stopped making the additional $50 monthly payments, and let your investment run for a further ten years earning 6%pa.

The balance after a further ten years is $14,908, meaning that for a $6,000 contribution, you end up with an extra $8,908, representing almost one and a half times what you put in.

Why did we go through these examples? Well, they may just remind you of how valuable it is to keep doing what you’re doing, or it may encourage you to look at your habits to see if you can source a little extra money on a regular basis to accelerate the repayment of personal or home loans, or to add to investments such as those in superannuation or otherwise in order to take advantage of the power of compounding.

Remember, a little change repeated regularly does convert into significant differences over time, even if it seems small in the beginning.

If you want to run some numbers yourself, you will find these calculators helpful.

Savings Calculator which can be used to calculate what an investment can grow to over time. The calculator can be used for all types of investment. Make sure you are realistic with your return assumptions.

Extra Repayment Calculator can be used to see what effect an additional regular payment off a home loan makes to how much interest you pay and the duration of the loan.

Lump Sum Repayment Calculator to look at the change a lump sum payment makes over the term of a loan.

Budget Calculator can be used to see where your money is going, which is sometimes useful to find new savings opportunities.

Watch this video to see the historical effect of compounding on the world’s population.