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The power of compounding interest

Sep 14, 2011

“I recently read an article that stated that by investing R500 per month you can save R2.3-million. You said that this is the power of compound interest growth although one has only contributed R60 000, the rest is all growth from the investment itself. Please explain this,” writes Petros.

Maya replies: This relates to an example of the power of compounding interest. In this example if you invested R500 a month from age 25 to 35 years old and then stopped contributing, by the time you reached 60 (25 years later) it would be worth R2.3-million.

This is how the power of compounding works:
In this calculation a 12% return per year was used which is what is expected from the markets over the longer-term.

After 10 years of contributions the investment is worth R115 000 (R500 per month plus growth). At 12% the money doubles in value every 70 months (five years and 10 months)

  • So after 70 months it is worth R230 000 (R115 000 x 2)
  •  A further 70 months = R460 000 (R230 000 x 2)
  •  A further 70 months = R920 000 (R460 000 x 2)
  •  A further 70 months = R1.8m (920 000 x 2)
  •  A final 20 months invested = R2.2m

(The slight difference is that it doubles in just under 70 months so there is a bit of extra growth)

For every five years and 10 months longer that you have that money invested it doubles — so the difference between investing for 20 years and 25 years becomes significant.

Now you can understand why the earlier you start saving, the more money you will have invested — it is not just the money you save but the growth on that money.

But also remember that this amount does not take inflation into account so it is not R2.3-million in today’s buying value. By that time R2.3-million would buy you the same basket of goods that R658 000 would buy you today assuming inflation is around 5%. But even so, just by starting to save early you can grow R60 000 to R658 000 in today’s value.

4 Comments

  1. hello! what type of returns can i expect from R7500 per month over 5 to 6 years? and where would you recommend putting this kind of monthly investment?

    Reply
    • Oh for a crystal ball! A unit trust fund that invests in equities would aim for a longer-term return of inflation plus 7%. At current inflation levels that would suggest a return of 13% p.a. I suspect that 10% is more achievable in the current environment. On that basis if you invested R7500 for six years and if the average return for the fund was 10% p.a you would have around R740 000. Right now most fund managers are recommending a fund with global exposure -so look for a unit trust that has a flexible mandate and that can also invest offshore.

      Reply
  2. Hi, which investment vehicle do you have to invest in to take advantage of the power of compound interst?

    Reply
    • In this article it was based on an equity investment so a unit trust for example. Any investment that delivers returns that you keep re-investing will create the power of compounding

      Reply

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Maya Fisher-French author of Money Questions Answered

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