Edition: July / September 2016
EXPERT OPINION
POWER OF COMPOUND INTEREST
Earn it or pay it, explains Liberty Corporate head of public
sector and corporate consulting Mathias Sithole.
One of the best known and frequently used
quotes on the power of compound interest
is attributed to the worldrenowned physicist and
scientist Albert Einstein. He is believed to have
said: “Compound interest is the eighth wonder of
the world. He who understands it, earns it. He who
doesn’t, pays it.”
Regardless of whether Einstein actually uttered
these exact words, the essence of this statement
is immensely potent. It cannot be disputed. And
Warren Buffett, the world’s most successful
investor and wealth creator, evidently agrees. He’s
often been quoted as having said: “My wealth
has come from a combination of living in America,
some lucky genes, and compound interest.”
Contrary to simple interest, which is calculated
on only the initial principal of a deposit or loan (in
other words, no interest is earned on the interest
that has been accumulated previously), compound
interest is calculated not only on the initial principal
and but also on the accumulated interest of
previous periods of a deposit or loan.
In basic terms, if you invest a sum of money
you will receive interest on the amount invested.
After the initial period, with compound interest you
will receive interest on the interest that you have
already earned in the past as well.
For example, if you invest R1 000 at 10%
compound interest per annum, after the first year
you would have earned 10% x R1 000 = R100
worth of interest. So your total investment is now
worth R1 100.
After the second year, you would have earned
R1 100 x 10% = R110 worth of interest and your investment would be worth R1 210. In the second
period, you therefore would have earned interest
of 10% on the interest of R100 which you earned
in the first period.
The power of compound interest is usually more
significant and noticeable over longer periods of
time. For example, assuming you can earn interest
of 10% per annum on an investment of R5 000,
after five years your investment would be worth R8
053 under the compoundinterest scenario.
By contrast, under the simpleinterest scenario,
your investment would be worth only R7 500.
Likewise, after 40 years your investment would
be worth R226 296 under the compoundinterest
scenario as opposed to only R25 000 under the
simpleinterest scenario. Obviously, had you
decided to put your money under the mattress,
it would have remained at R5 000 (and been
ravaged by inflation).
The graph shows the growth of a
R5 000
investment over a period of 40 years at 10% per
annum under the different compound and simpleinterest scenarios.
There are many practical applications of
compound interest, such as loan repayments,
but perhaps none demonstrates the power of
compound interest more clearly than saving for
retirement.
For example, if an individual contributes R5
000 at the beginning of every year for a period of
40 years, he/she would have invested R200 000
over this period. Again assuming 10% per annum
compound interest, this investment would amount
to approximately R2,4m after 40 years.
Interestingly, the contributions made during
the initial 10 years account for almost 65% of the
total investment amount at the end. This clearly
demonstrates the power of compound interest over
long periods of time and shows why it’s important
to start saving as early as possible.
Sithole . . . dramatic differences 
When it works against you
At the same time, be warned that compound
interest can be a doubleedged sword in some
circumstances. It’s particularly pertinent when you
have to make repayments on some sort of loan
e.g. monthly mortgage instalments on a house,
financing your motor vehicle and paying off creditcard
debt or student loans.
Say, for example, you have taken out a loan for
R5 000. After five years, the loan repayable would
be R8 053 and after 40 years a whopping R226
296! The point is that, due to compound interest,
you spend a lot of your future income for the
benefit of owning something now when you buy it
through a loan.
In these cases, you are the one paying
the interest on the loan as well as interest on the interest that has accrued. This situation is
particularly severe for consumers in times of high
interest rates.
So the moral of the story is to use compound
interest in your favour when investing, but
minimise your debt as far as possible by
preventing it from working against you.
www.liberty.co.za.
