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Compound interest, explained

I'm building my wealth | | 2 min read

Albert Einstein once called compound interest ‘the eighth wonder of the world’. That’s high praise indeed, and places compound interest alongside the Great Pyramids of Giza and the Statue of Zeus at the Olympia. So, how does compound interest work, and, more importantly, how can you make it work for you?

What is compound interest?

Compound interest is a cornerstone of investing. Once you’re able to understand it, you can unlock its domino effect, and let your money do the work for you.

First, let’s look at interest. Simple interest is a fixed percentage payment on a lump sum. Say you have $1,000 in a bank account and see a 3% return for the year. That adds up to a balance of $1,030. 

Compound interest takes this concept but allows you to earn interest on your interest, multiplying your money even further.  

Let’s use super as an example. Take a 25 year old female, with a starting super balance of $20,000. If she was to earn the average Australian salary of around $60,000 throughout her lifetime, with a lifecycle investment strategy*, she would look to retire with $541,246 at age 67.

That’s calculated based on a steady income throughout her lifetime and is the combination of regular employer contributions to her account and annual interest compounding to create a super nest egg.  

As you can imagine, once you start to play around with additional contributions the end figure can grow substantially. With salary sacrifice contributions of $100 per week ($5,200 per year), our example member’s super balance would grow to $906,175 by age 67.

That’s the power of compound interest. Visit Catholic Super’s retirement calculator to see how much you could retire with, and how additional contributions could boost your super over time.  

Compound interest – is it a young person’s game?  

As you can see in the example above, time is one of the most important factors when it comes to compound interest. The sooner you’re able to put your money into an account and leave it there, the more compound interest you can earn.

Starting out at 20 is the best, 30 is great, and 40 is still good. But it is worth noting that the sooner you starter the longer you will have to benefit from compound interest.

Compound interest and super

Topping up your super on a regular basis can make a real difference.  

The good news is most people receive automatic super contributions from their employer. But if you’d like to top that up even further, you have options, including salary sacrifice.  

The term ‘set and forget’ is often used when it comes to super, but this is something that can be beneficial when it comes to compound interest. Over time, small contributions can make a huge difference. As a concept it can be hard to grasp, but once you do, you’ll also start to appreciate it as the eighth wonder of the world.  

*Lifecycle investments change with your age. When you’re young, and you have a long time until you access your super, a Lifecycle strategy invests in mainly growth assets, which will give stronger long-term returns, but a greater chance of a negative return in any one year. As you approach retirement, the Lifecycle strategy moves you into more defensive assets which deliver lower but more stable returns, suitable to drawing a regular retirement income. The lifecycle strategy used for these calculations moves you from around 90% growth assets at ages under 55 to 60% growth assets after age 70.  

Authorised by Togethr Trustees Pty Ltd (ABN 64 006 964 049; AFSL 246383) ('Trustee') the trustee of the Equipsuper Superannuation Fund (ABN 33 813 823 017). Catholic Super is a division of the Equipsuper Superannuation Fund (ABN 33 813 823 017). Financial advice services may be provided to members by the trustee's related entity. 

Togethr Financial Planning Pty Ltd (ABN 84 124 491 078; AFSL 455010). The information contained herein is general information only. It has been prepared without taking into account your personal investment objectives, financial situation, or needs. It is not intended to be, and should not be, construed in any way as investment, legal or financial advice. Please consider your personal position, objectives, and requirements before taking any action. Past performance is not a reliable indicator of future performance.

© 2020 Togethr Trustees Pty Ltd. For further information please our contact our Service Centre on 1300 655 002 or visit our website: csf.com.au.

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