Your Compounding Returns

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Albert Einstein infamously said this.

Now I’m no scientist, however I can absolutely attest to the power of compound interest being incredibly valuable when it comes to growing your overall wealth.

What Einstein also went on to say however in my view is even more important when it comes to harnessing the power of compound interest, and it is this second quote I want to spend time exploring with you:

“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”

What did he mean by this?

Let’s start with the positive part of this quote, “He who understands it, earns it” by looking at a worked example.

Have you ever mapped out compound interest?

If you Google "ASIC Compound Interest Calculator", you will find a useful tool which emphasises Einstein's point.

Whilst you can go down rabbit holes playing with this tool, to highlight what Einstein meant about understanding the power of compounding interest so that you “earn it”, or in other words, grow your wealth effectively, plug in these numbers:

Initial deposit = $50
Regular deposit = $50
Deposit frequency = Weekly
Compound frequency = Annually
Number of years = 30 years
Interest rate = 5.00%

Let’s assume you were able to save and invest $50 each week for 30 years into a portfolio that gave you a 5% return, payable at the end of each year. Upon receiving this 5% return at the end of each year, you decided to keep this within the portfolio so that overtime your total invested amount compounded and grew by a combination of the weekly $50 investments you made and the 5% return you received at the end each year.

How much of your total return at the end of 30 years do you think is due to compounding?

More than 50%.

Yes, that's right.

If you plug in these numbers to the ASIC Calculator, after 30 years your portfolio is worth $172,957.

Of this, $78,050 is the total amount of regular $50 investments you made each week and $94,907 is generated by compounding, that is, by keeping the 5% return you received at the end of the year within the portfolio, otherwise referred to as reinvesting.

THAT is the power of compound interest which Einstein referred to.

The other important part of the power behind compounding is time. Over time, year on year, as you keep reinvesting your returns back into the original portfolio, investment or bank account, the results build up. In the first year the impact looks small, but over 5 years, then 10 years, then 20 years and in our case, 30 years, the power of compounding is extraordinary. 

By looking at the ASIC Calculator, you can see the impact clearly!

Note, most micro investing accounts (visit Your Investment Platform to learn more about these) offer better return opportunities than 5% each year in the long-run, even when you take into account fees and transaction costs, however I am being conservative in our above example. You can play around with the ASIC Calculator figures, however I prefer to stay conservative with my investment return expectations.

BUT REMEMBER!

Whilst the power of compounding helps you “earn it”, if you understand it, if you do not apply this understanding, you will “pay it”.

What Einstein meant is two-fold.

First, if you do not reinvest and allow both time and compounding to work their magic, you will lag behind in the long-run when it comes to your overall returns.

Second, as positive as compounding can be for investment portfolios if you reinvest, it can be equally as powerful in a negative way for mortgages when you are paying down debt.

For example, if you think you are applying for a $500,000 mortgage, over 30 years, even if you pay down principal and interest on a monthly basis at a flat rate of 5.00%, you will end up paying almost $500,000 of interest ON TOP OF your $500,000 mortgage.

Don’t believe me?

If you Google “ASIC Mortgage Calculator” and click “How much will my mortgage payments be”, plug in these numbers:

Amount borrowed = $500,000

Interest rate = 5.00%

Repayment frequency = Monthly

Length of loan = 30 years

Fees = $0

How much of your total mortgage repayments at the end of 30 years do you think is interest due to compounding, if you just pay the standard monthly principal-and-interest figure calculated by your mortgage provider?

Almost 50%.

Yes, that's right.

If you plug in these numbers to the ASIC Calculator, after 30 years your total repayments for a $500,000 mortgage is $966,279.

Of this, $500,000 mortgage you applied for and $466,279 is interest on your mortgage generated by compounding. This doesn’t even include fees, stamp duty or any other cost involved with applying for a mortgage.

So! What's the point of all of this?

Compounding interest over time is powerful and important to understand. 

If you have a mortgage on your home, pay down the principal as fast and as frequently as you can.

If you invest, use dividend reinvestment plans and start investing as EARLY as possible.