Compound interest is the magic that happens when you earn interest on interest or growth on growth.
It can supercharge your investment, especially when you have time on your side.
This is the reason why, when asked what the most powerful force in the world was, Albert Einstein apparently replied “compound interest”.
He is also widely believed to have described compound interest as “the eighth wonder of the world” and to have said: “He who understands it, earns it, he who doesn’t, pays it.”
It is easy to underestimate how powerful compound interest is in making your money work for you, especially when you start investing with a small amount, and it feels like it will never amount to much.
However, small amounts saved for long periods can also harness the power of compounding as long as your growth or interest rate beats inflation.
It is also easy to forget that when you take out debt, compound interest works against you – which is why Einstein said if you don’t understand it, you pay it.
The longer you take to pay off debt, the more interest you will pay. This is because interest is added each month to the amount you owe in addition to the interest added in previous months.
The King who didn't get it
It helps to remember an often-told tale about a Persian king who loved games and was presented with the game of chess. Happy with the new game, he asked the inventor of the game how he could reward him.
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DO YOU KNOW THE RULE OF 72? If you want to know how quickly the money you have saved will double, use the rule of 72. Take 72 and divide it by the interest rate you are earning on your money. The answer will show you how quickly your money will double.
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The man asked for a grain of rice to be placed on the first square of the chess board and for that grain to be doubled on the second square, and on each subsequent square until, the 64th one.
The king, who did not understand the power of exponential growth, readily agreed.
However, when the grains were counted out, they soon mounted up: at the end of the first row, there were only 128 but by the 21st square, the king had to supply more than a million grains.
On the 41st square, the king was liable for a trillion grains and by the time the 64th square was reached, the king was up for 18-trillion grains of rice.
According to the legend, the reward bankrupted the king, forcing him to hand over his kingdom.
Although you are not likely to double your money each month or year, the legend illustrates the power of compounding.
If you reinvest the dividends and interest you earn on your investment, they will compound at a more modest level, but over many years compounding can get you ahead of someone who saves more than you but starts later.
The Actuarial Society of South Africa illustrated the example of SAM and SAM's Bestie below.
