Your financial life could be divided into three basic financial phases:
- Phase 1 (childhood and studying): you acquire the skills to generate an income.
- Phase 2 (working): you generate an income, live below that income and save.
- Phase 3 (retirement): you live on whatever you saved during phase 2.
Once you get to retirement what you have available is essentially what you did not spend while you were working. In essence, saving is simply deferred spending.
One of the most important concepts to understand during phase 2 of your life is the mathematical magic of compound interest. This is one of the most powerful wealth creation tools available to you.
Imagine that you saved R1 000 per year over a 40 year period and your money grew by 10% per year. You invest your R1 000 at the beginning of year 1. Your money will earn R100 during the course of that year. The balance at the end of the year will be R1 100. At the beginning of the next year you add another R1 000 to the investment. Your investment starts off with R2 100 at the beginning of year 2.
During year 2 your money will earn 10% interest on the original R1 000 you invested at the beginning of year 1, the R1 000 you invested at the beginning of year 2, as well as the R100 interest your money earned during year 1.
In year two your money will start to earn ‘compound interest’ which is interest on interest you earned in previous years. The interest for year 2 will be R210. The balance at the end of year 2 will be R2 310.
In year 5 you will earn interest on the R1 000 you invested in each year up till then, as well as on the interest that you earned in years 1, 2, 3 and 4.
In year 8 you will earn more in interest than you are saving. You will still save R1 000 that year but your money will earn R1 144 in interest. From that point onwards your money will be working harder than you.
Multiplying your money
After 12 years the interest will be twice as much as you are saving. In year 15 the interest is 3 times as much as you are saving. By year 40 you will have invested a total of R40 000 out of your own pocket, but the interest that your money will earn in that year will be R44 000.
By that stage your money will earn more interest in one year than you have invested over 40. That demonstrates the power of compound interest.
Table: Investing R1 000 per year, earning 10% per year
The illustration above uses R1 000 per year in order to explain the concept simply. In reality the amount you should be investing is 10% – 15% of your gross income into investments. If you did this over a 30 to 40 year period your portfolio could be generating more in interest than you are earning from your job.
Compound interest is arguably the most reliable way to achieve financial independence, which is where you can support your lifestyle from your capital and no longer need to work.
The key is to start soon enough and not to stop. If you have broken service do not cash the investment in and spend the money. If you spend it you reset the clock and you go back to year one. Rather reinvest the money from your pension or provident fund whenever you move from one employer to another. Start early, maintain the continuity and harness the mathematical magic of compound interest.