Get rich by harnessing the power of compound interest

The most powerful tool for getting richer happens while people are sleeping, and here’s how it can be harnessed.

Compounding returns send investors’ wealth higher and higher. Picture: iStock

Albert Einstein reportedly called it the eighth wonder of the world, and when a genius speaks, it often pays to listen.

Compound interest may have an uninspiring name, but what it lacks in pizzazz it more than makes up in awesome power that can turn everyday investors into multi-millionaires.

And in today’s times of high interest rates that could climb again after the Reserve Bank’s Melbourne Cup Day board meeting, it’s important to understand how compound interest can be harnessed.

In simple terms, it means earning interest on your interest on your interest, and so forth. Rather than spend income you get from cash deposits, share dividends or other investments, you can pump the money back in to buy more assets that in turn multiply over time.

Compound interest is perhaps better described as compounding investment returns, because it is often most powerful when it’s not bank interest but assets such as real estate or shares.

It’s why big is beautiful when it comes to investing. The larger the asset, the more it grows and the richer people can get.

However, it won’t happen overnight. Compounding works best when measured over decades.

Anyone can project its powerful impact using free compound interest calculators on countless financial websites including moneysmart.gov.au.

SAVINGS

Bank interest is the simplest measure, and someone who puts $5000 into a deposit account paying 5 per cent and then adds $100 cash each month will end up with almost $24,000 after 10 years – giving them a total interest gain of $7000.

Keep it going for 20 years and the end result is $54,000, and the interest will exceed the total deposits made. After 30 years our saver has a handy $105,000 including an interest component of $65,000.

The power of compound interest is spectacular over several decades. Picture: iStock

PROPERTY

Compounding works wonderfully well with real estate values, even if investors use their rental income to repay mortgages rather than reinvest, because the sheer size of the asset means even modest growth produces big profits.

For example, Moneysmart’s calculator shows a property bought for $500,000 and growing by 7 per cent each year would be worth $983,000 after 10 years, $1.9 million after 20 years, and $3.8 million after 30. Add a second investment property and those profits can double.

SHARES

Many major companies have dividend reinvestment plans that allow shareholders to buy more stock rather than pocket half-yearly dividends. Good shares enjoy good capital growth over time too, so investors are getting a double benefit.

And in share market downturns, their dividends have more buying power to snap up shares that are effectively selling at a discount.

SUPERANNUATION

Most Aussies enjoy the power of compound through their super funds because their money is locked away for several decades and all interest and other income gets reinvested until retirement.

Moneysmart has some handy superannuation calculators that help illustrate this.

Compound interest is great for people of all ages. I’ve seen parents help their children become teenage property investors by putting $100 a month away for them since birth, then letting compound interest and the share market help turn it into a decent deposit by age 18.

To harness its true power, consider these three steps:

• Start immediately, even with a small amount, because every dollar adds up and compounds over time.

• Have a written plan that uses projections from compound interest calculators to build road map to future wealth, and a reference point to check in future years.

• Go for growth assets such as property or shares, which deliver both income and capital gains. Today’s bank deposits are higher than normal, but still below inflation, and could fall soon.

Originally published as Get rich by harnessing the power of compound interest