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Chapter 1: What is compound interest and why is it important?
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Welcome to the Australian Finance Podcast, a podcast for people who want to learn more about their personal finances and get the most from their money. This series is hosted by Kate Campbell from HowToMoney and Owen Raskovich from Rask Finance.
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Chapter 2: How does saving money provide us with choices in life?
The Australian Finance Podcast is provided for educational purposes only. The information is general in nature and does not take into account your needs, goals or objectives. What that means is the information does not apply to you specifically. So consider getting the advice of a licensed and trusted professional before acting on the information.
Welcome to episode 14 of the Australian Finance Podcast, Kate.
Yes, we are going to be talking about the power of compound interest today.
Wonderful. And this comes through from a request on Twitter, I believe it was.
Yes.
Saying that we should cover compound interest in a little bit more detail.
Because it's one of the most important financial lessons.
We've kind of beat around the bush a bit with talking about compounding. Yeah. And we're going to just flesh it out a bit.
We probably will mention compound interest in every single episode and every finance article you'll see something about compound interest.
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Chapter 3: What are the essentials for achieving financial freedom?
So choice allows us to have control. And so when we think about things like do I want to coach my kids' soccer team in 10 years or do I want to put them in after school career because I'm going to have to be working late hours or whatever? Or do I want to be able to take my family on a holiday or – Not.
Do I want to be able to say, go stick it to my boss because I don't need to work here or not, right? And that's a bit flippant, but it's about having the choice and control over your own destiny. And I think that's what money does for me. And I think for most people's definition of financial freedom, that's kind of like what it is.
And so when it comes to what's required to get to that position, I think obviously we talked about essentials. One of the things being that you need to be in control of your budget.
Yeah.
Right? And everyone needs to know that they need to spend less than they earn. And what they need to do with the difference is compound. Yeah. And this is why we say it's probably the most important tool in your kit, right? Spend less than you make, compound the difference. Yeah.
and so albert einstein i think called it the eighth wonder of the world but why don't you flesh it out for us what is compound interest in a nutshell so you've got your fifty dollars actually hundred dollars is easier to go with so it's in the bank and you're getting three percent interest per annum which would be amazing i'd like that right now um so by the end of the year
Theoretically, you'd have $103. But because the money – so you're going to get your interest payment each month. So whatever that is.
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Chapter 4: How does compound interest work in practice?
I should have put that up. So you get that portion, one-twelfth of 3% each month. And so the following month, you don't just get interest on the $100. You get interest on the $100 plus the interest from January. And then you just keep building. Yes. So by the end of the year – you'll have earned more than $3 in interest. And then that just keeps snowballing. Obviously, $3 is pretty small.
It won't even buy you a coffee in Melbourne. But when we're talking about a larger amount of money, so $100,000 –
Or your superannuation.
Yeah. That really starts to compound. And bank is lower level. But if we're talking about investing where you might get a 7% return and you – instead of getting that income paid out to you or spending it, if you actually reinvest that 7%, then next year, instead of getting –
returns yeah seven percent on your hundred thousand dollars you get on your hundred and seven and yeah hundred and seven plus yes yeah okay so what you're saying to us is that we get not only the interest or the returns on in this example 107 000 or 103 we're getting a little bit more each and every year
And then over a long period of time and with a lot of money, that turns into a big difference, right?
Yeah, and it's the snowball effect. So here's some numbers I did prepare earlier because this $103 isn't working. Okay, so we start with $0. We're depositing $1,000 every month for 30 years and we're having a 7% per annum return. At the end of 30 years... you're going to have around $1.2 million. Wowza.
And most of that is actually going to be made up of the interest or that 7% interest rate you're getting. So in total, you have only deposited $360,000. Wow. And $860,000 on top of that will be interest. And if you have a look at the charts, we'll put some in the show notes, but also having a look at the ASIC Money Smart Calculator, which we love, you'll actually be able to see at the start,
You'll be putting in your $12,000 a year and it won't look like much. You won't be getting much in terms of returns. But as that snowballs and you reinvest that 7% return every single year, over 30 years, you're ending up with a massive pile of money that can sustain you during retirement. And that's just your regular $1,000 every month, 7% return. So we're not looking for anything insane.
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Chapter 5: What impact does time have on investment growth?
Yep. Okay. All right. Let me give you a hypothetical question, Kate. And let's say we have a 20-year-old. Yep. Plans to retire at 60, right? And they save $36 a week and they put it into their investments, right? And let's say we have a 50-year-old who puts $1,000 away a week. So $36 versus $1,000. And they both want to retire at 60. Who comes out with more money?
It's going to be the 20-year-old. Yeah. I'm assuming the 50-year-old doesn't have any other savings.
Yeah. So, in this scenario, the younger person who saves $36 a week versus the older person who saves $1,000, the younger person still comes out ahead. Yeah. And why? Because of time. The longer you allow your money to compound, the greater returns going to be. Yeah.
And that's in your 20s and 30s, you have a lot more time and you can really make use of this snowballing effect on your wealth. So, putting your $1,000 in, that can be even less if you're planning to look on a 40-year horizon.
I think that's probably the hard thing, visualizing 30 years' time because you're locking your money up for 30 years mentally in this plan and it's so far away and it seems like out of reach, but- If you put the steps in now and you just let it snowball in the background, you can really make a massive difference to your retirement.
I think a way to think about that to bring down the time, like the way mentally to shorten the feedback loop, if you like, like that positive cycle is to think about it. And you'll hear people say this a lot. The first $1,000 to save is the hardest $1,000 to save. The next one probably take you just over half as long and the one after that, less than half of that again.
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Chapter 6: How can small investments lead to significant wealth over time?
And it's like, it doesn't matter if it's $1,000, $10,000, $100,000. Once you get to that one domino, it's like everything else falls into place quicker behind that. And the reason why it does is because of compound interest. You get to a point... And then the money that you already have invested is working for you. And all of a sudden, everything just falls into place.
Like I remember back when I was younger, a friend of mine sent me a message saying, hey, how good is this? I've just got to $100,000 net worth. Wow. Yeah, and I was like, that's awesome. Yeah. This guy was in his mid-20s, right? So he saved, saved, saved, saved, saved. And he got to that $100,000 and he was just over the moon. But I don't know his personal situation, but I imagine now it's –
a lot more than that and we're only a few years on from then so uh my point is that it took him you know seven years of hard saving and life choices but he got there and i reckon it'd be 300 plus 400 plus it's only a few years later once you hit around that hundred thousand dollar mark it just starts going crazy in the background even if you don't add anything else to it
Because like you said, if you have 7% return on $100,000, that's $7,000 a year. If you think about it, you're not actually doing anything to get the 7%.
And if you're reinvesting it, then it's just going to snowball in the background.
That's it. The next year it's going to be $107,000 and you're going to be earning 7% on top of that because you're allowing it to compound again and again and again. And your savings goals are just going to fall like dominoes. So the point is, there's three things, and we've talked about these. Time, the amount of time you have to invest. Obviously, the longer, the more compounding.
The amount that you save, obviously, the more you save, the more you have invested. And the last one is the average return. So how much are you getting? And if you stick your money in a savings account, probably not as good as shares.
But I think it's also if you're starting in your 20s, then you don't need to be putting as much away. Whereas to get the same results starting 20 years later, you're going to have to be putting a lot more away every month in terms of what you're investing. So time's really on your side if you're in your 20s.
Yeah. Another thing is that this can also go against you. Like if you've ever felt like you're running a million miles an hour but you're not getting anywhere because you have credit card debt or something like that, you're experiencing the opposite of compound interest. It is effectively the bank is earning compound interest and you're paying it.
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Chapter 7: What role does risk play in investment returns?
You wouldn't. If your debt's accruing interest at a greater rate than 7%, then yeah, it's 7%, 10%. Because your investments might be growing, but your debt's growing faster.
True. And we've talked about this before, is that one of the variables is how much return you're getting for your money. Obviously, 7% is better than 3%. That's just basic maths. But obviously, we've got to consider the risk as well. So some people think, well, just make riskier investments and therefore I'll make more compounding. That's not the way it works.
You get to a certain point where the amount of risk that you're taking overwhelms the returns you're going to get and you end up going backwards. So, 7% is probably a reasonable figure, a reasonable expectation. But if someone's promising you 15% returns, 20% returns, obviously no one can make that type of promise. Obviously, the higher we can compound, the better. That's why I invest in shares.
We've covered this. That's why you invest in with robo-advisors, ETFs, etc. Because that's where we feel we get the best return.
I think it's also important to note that without having to go for an aggressive product, you can build wealth outside investing. Sorry, not investing, putting your money in just a term deposit. If you're investing in shares and various similar products, you don't need to be greedy. You can just put that money away, get your average return and build a substantial amount over a 30-year timeframe.
You just... It does require patience, it does require like building a plan and sticking to it and you have to be able to withstand market.
Gyrations, yeah. Yeah, that's a big one, temperament, right? If you're going to sell out as soon as something goes wrong, if you're investing in shares, you're never going to compound.
Yeah, if you keep selling things, compound interest does not work.
Yeah, I'll throw one out there just as a final life lesson, I guess. So everyone's heard of Warren Buffett. You can't see this. I'm staring at him on the wall here. I've got a picture of him in my office.
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Chapter 8: How can understanding compound interest change your financial future?
I think it was his 50th, yeah. And he's about 86 now, 87. And he's now worth, oh, the better part of $90 billion. Right? So when you think of those numbers, $300 million, you think, you know, almost $90 billion.
That's a bit more than just normal compound interest type thing.
It is. But when you think about it, right, it means he earned more than 99.7% of his money after the age of 50. Yeah. Right. He was a millionaire when he turned 30, just before he turned 30. So if you think about that, he was already wealthy, but he wasn't extraordinarily wealthy until later in life. And the reason why, it's not because he worked 99.7% more hours in a day.
It's because he let his investments compound. And those compounding returns allowed him to achieve that later on in life. Yeah. So that's just a huge – that's like an overwhelming and ghastly example of how things can go really well. Yeah. But it's a small example. That's why older people tend to be richer than younger people because they've had time to let it compound.
Yeah.
That's a lesson. We've got some great resources in the show notes.
A few more articles sort of going in depth on compound interest and giving some examples. And I definitely recommend having a play around with the ASIC Money Smart Calculator. It's probably one of our favorite calculators.
of all time so i much prefer it over the school calculator um but that's really good to play around with different scenarios and really you can look at how the numbers look at a 10 year time frame and then suddenly you put 50 years in and then just the wealth just goes crazy it's amazing you'd be surprised like i used to spend hours on this thing you'd be surprised at how little you have to invest now less than five hundred dollars whatever
to get to that million-dollar mark or whatever in a certain amount of years.
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