The power of compounding

However, like any powerful force, compound interest has the ability both to create and destroy. Compound interest also applies to debt, which is why unpaid debts escalate at an ever-increasing rate and can soon become unmanageable. Harnessing the positive power of compound interest and avoiding the destructive effect of compound debt is the secret of creating wealth.

Compounding investment growth

Compound interest is the effect of earning interest upon interest. The table and graph below show the effect of an 8 percent return per annum, compounded monthly, on a R1000 lump sum:

The original investment has grown to R2 220. Compound interest has just delivered R1220 that you have not had to work for.

Compound growth is even greater when you invest in growth assets like equities, which, over time, provide higher returns than cash.

Based on the returns of the JSE over the last 10 years, a R1000 investment would now be worth R3500. That is R2500 created by the powerful force of compound growth.

Compounding debt

Compound interest works against you when you take on debt. Interest on debt is always higher than that on a money market investment because that is how banks generate profit. Banks also charge a risk premium for lending money.

When short-term interest rates (money market) sit at 5.5 percent, the interest on short-term debt such as credit cards, personal loans and store cards is generally in excess of 15 percent, making it a good investment for the loan provider but a poor choice for the borrower.

To put it in perspective, if you purchase an item worth R1000 today and settle the debt over three years, you will have repaid a total of R1248 due to interest (at 15 percent, compounded monthly). You have paid 20 percent more for that item.

Many consumers get very excited when they can get a 20 percent discount on a sale without realising that you can get a 20 percent discount every day if you simply pay cash for the goods.

The compounding effect of interest on credit is exacerbated when you do not pay the monthly interest on your purchase.

For example if you purchased an item for R1000 at an interest rate of 15 percent, compounded monthly, and you were unable to meet your monthly instalments, by the end of the year you would owe the bank R1161. If that debt remains unpaid by the following year you will owe R1347. Within five years that debt will have risen to R2107. By year 10 you will owe R4440.

If you compare this to your 8 percent a year investment, which would be worth R2200, it is clear that compound debt is by far the more powerful force, which is why paying off your debts should be your first priority.