It’s not exactly rocket science, but based on its ability to turbocharge your savings, Albert Einstein called ‘compounding returns’ the most powerful force in the universe – and a super huge IQ isn’t needed to make it work for you.
Stripped down to its bare essentials, compounding returns is all about how adding regular amounts to the money you’ve already got can accelerate your savings at a much faster rate.
For starters, let’s look at the difference compounding interest monthly versus annually can make.
For example, take $25,000 in a savings account earning 4 per cent interest annually, and after five years you’d have $30,000.
However, if your interest compounds monthly, you’ll simply earn more money. That’s because it’s being calculated on a higher balance each month.
For example if you had the same $25,000 in a savings account earning 4 per cent annually that’s also compounding monthly, after five years you’d have $30,525.
That’s great – a difference of $525 with no extra effort from you.
But if you continue to put money into your savings, you’ll effectively put a rocket under your ability to save more, and that’s got to be compelling in anyone’s language.
Here’s another example that compares simple interest on a $10,000 investment at 5 per cent annually, paid at the end of the term, with compound interest on the same investment and the same annual interest rate paid monthly.
Small, regular amounts stack up
One of the single biggest reasons for saving or making additional contributions to your super is to reap the benefits of both capital growth, and the power of compounding returns.
Believe it or not, squirrelling away small, yet regular amounts make a big difference over time.
Here’s one powerful example that most people have the ability to implement right now. What would happen if you put aside $50 a week and invested it into the share market every time you save $1000?
Short answer: If those shares earn 9 per cent annually, in 30 years you’d have $442,000 in wealth – and this would be achieved by investing only $78,000 of your own money. That’s a damn good outcome, and you can apply the principles of compounding returns to literally any investment.
Key drivers of compounding returns
The principles of compounding returns are based on three key drivers, including the rate of return (or the interest rate you receive), the amount of money you contribute, and the timeframe you choose.
The beauty of committing to a longer timeframe is that every month, the rate or return (or interest rate) is calculated on a higher balance than the month before (aka returns on returns).
Remember, every time the boss pays your super guarantee (SG) contributions, you’re repeatedly getting returns on higher monthly returns, and maximising the power of compounding interest.
But you can also give your savings balance an additional nudge by doing your own ‘heavy lifting’.
For example, every time you make additional contributions to your super, either through salary sacrificing or non-concessional amounts (on which you’ve already paid tax), you’re maximising the overall effect that compounding returns will have on your money over time.