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Is Compounding Interest Over-Rated?

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Contributor:
Mary Holm
Mary Holm

Question:

I read a lot of financial advisors talking up the power of compounding interest. With average deposit rates of around 7 per cent (roughly 4.5 per cent after tax), I can't see how this compounding is a significant advantage.

I do not want to discourage savings, but as an example, after say 25 years of savings, the majority of what you have saved at 4.5 per cent is still your money and not what you have earned as interest. This is assuming you save at the same regular contribution rate. If you increase your savings rate, it would be even later.

I did a quick calculation of regularly saving $100 per month for 30 years at 4.5 per cent interest. The interest you have earned only begins to exceed what you have deposited in the last 2 or 3 years i.e. after 27 years!

No wonder so many people seek instant gratification from spending, when benefits for savings are so far off.

I have a different attitude to savings. I see it as deferred spending. What I don't spend now, I can spend at a later date. The interest I earn is simply a bonus, but not a significant motivator.

Answer:

Mary Holm: I think the point you are missing is that, if you are making regular savings, some of the money you deposit has been invested for much less than 30 years. A third of it has been there for less than 10 years. So the interest on that money hasn't had all that much time to compound.

Even so, I reckon compounding is still pretty good. In your example, you would deposit a total of $36,000 over the 30 years and earn interest totalling about $38,700. Sounds quite significant to me.

Compounding is more impressive, though, if you put all the money in at the beginning and leave it to grow. If, say, you inherited the $36,000 and it earned 4.5 per cent over 30 years, the interest would total almost $100,000 and you would end up with close to $135,000.

If you left your money there for just another 18 months, the $36,000 would have quadrupled. You have to acknowledge that that is significant.

True, over shorter periods compounding is not as exciting. Even so, $100 a month for just 10 years totals $12,000, and 4.5 per cent compounding interest on it totals more than $3000. That has still boosted your savings by 25 per cent in a really safe investment.

And if the $12,000 were a lump sum, it would grow to $18,600 - better than a 50 per cent boost.

Readers can work through other examples on the regular saving and lump sum calculators on the Retirement Commission's website, www.sorted.org.nz

There's another important point in all this. These days term deposit rates are way higher than inflation, which is currently around 3.2 per cent and is predicted to fall to around 2.3 per cent over the next several years.

It hasn't always been that way around, as our graph shows. From the late 1960s to the early 1980s, inflation topped interest rates. If you put money in a term deposit it bought less when you took it out again. There was a huge disincentive to save.

These days, though, your savings will buy you considerably more later than now, even after tax.

While some people will always prefer instant gratification, those with will power will be rewarded for waiting.

 

Mary Holm is the author of bestselling books on KiwiSaver and personal finance. She is also a highly praised seminar presenter. Her written advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following that advice.  

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