Once you understand what compound interest is all about, you'll want to make the most of it to ensure a steady financial future for your kids, too.
So, what’s the secret to compound interest? The value of compound interest is not in saving vast amounts – instead, it’s all about when you start saving.
According to Danelle van Heerde, Head: Advice Processes and Tools at Sanlam Personal Finance, it is important to understand the basic principle of compound interest. “It’s effectively earning interest on interest on interest. So, once you have put your savings aside, however insignificant it may seem, you do not have to do anything, bar watch your money increase. It’s the best way for your money to grow over the long term.”
How can it benefit you if you’d like to save for your children’s education?
This lesson is an important one for parents in particular. School and university fees are becoming increasingly burdensome on parents – but making use of compound interest is a great way to reduce this load.
Van Heerde shows how:
- By putting away just R250 a month for your child when he or she is between the age of 5 and 10, and then leaving that money in the account, your child will have about R50,000 at age 20 – a great way to help pay the fees.
- Or you can leave this to earn more interest, and by 65 your child will be worth R2.1-million.
- Compare this to your child starting to save for himself as an adult aged 25 - an active investment of R250 between 25 and 65 will only amount to R1.05-million.
“That’s double the saving, by simply putting R250 every month for five years, when your child is young. It’s not surprising, looking at figures like this, that Albert Einstein referred to compound interest as the eighth wonder of the world.”
What about inflation?
According to Van Heerde, there is one element to remain cautious of: inflation, otherwise known as the general rise in price of goods and services. Inflation is currently running at 6.1 percent year-on-year. That means the interest you earn must be more than inflation, for it not to eat into the value of the money you’re saving. (For example, if your savings generate five percent interest, but inflation is at 6.1 percent, it means that you will be able to purchase less with your saving in future than you can today.)
Given the effects of inflation, where should I put my savings in order to experience the full benefits of compound interest?
The first step is to check whether your company has a retirement plan in which you can save every month. If not, set up a direct debit from your bank account to a good retirement savings product (which offers an inflation-beating investment return) as soon as your salary enters your account, to prevent you from spending it first.
You could also look into the benefits that unit trusts or exchange traded funds offer – two easy ways to invest your money, while allowing you to withdraw the money when you need it.
Speak to an experienced registered financial advisor to establish the best way for you to make the most of compound interest. “Everyone’s situation is different, and an expert could help you find the best savings products for you. But even so, there’s no reason or excuse not to use the power of compound interest to benefit your savings strategy. It’s especially vital when you’re young, but even if you’re past 50 years of age, you can expect to live another 35 – 41 years, so don’t take that for granted. To think that setting aside just 35 cents an hour for your child when he’s five could make him a multi-millionaire when he retires – that is pretty empowering.”