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The ‘super’ power of compound interest

In this article, we look at a critical part of investing—compound interest—and how by letting it work its ‘magic’, it can help build your super investment over time…even while you sleep.


What is compound interest?

Compound interest is one of the cornerstones of investing. For an investor, compound interest means receiving interest on interest already earned or receiving earnings on accumulated earnings. It’s the ‘secret sauce’ of investment and is one of the only true ‘free lunches’ around—as long as interest or earnings rates are positive.

According to Albert Einstein: “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

Compound interest works very well when it comes to super. Why? Because time is critical for the compounding effect to work best. The longer your money is invested, the more potential to boost your super balance and the more you are likely to have at the end (providing returns are positive). The effect of compounding over time, combined with reasonable investment returns (e.g. at least 5% a year for shares), can really boost your super balance.


Be in it to win it

You may have heard the phrase, “it’s time in the market not timing the market that counts” and this can certainly be applied to compounding. The earlier you begin an investment the better, because you’re giving more time for compounding to increase the value of your investment.

ASIC Money Smart’s website has a good example of how compounding works in practice:

  • Investing $10,000 for 5 years at 5% p.a. with interest paid at the end of the term would earn $2,500 in simple interest over 5 years. Result: $12,500 in principal and interest at the end of the term.
  • Investing $10,000 for 5 years at 5% with interest compounded monthly would earn $2,834 in compound interest over 5 years. Result: $12,834 in principal and interest at the end of the term.

These calculations are shown in the table below.

Compound interest vs simple interest

Source: ASIC

The second table illustrates how the monthly effect of compounding really boosts the amount invested, how this effect is made more powerful the longer the money is invested, and how important the level of interest (or return) is when it comes to compounding as the interest rate has a multiplier effect.

This principle is illustrated in the chart below (as a hypothetical example) over a 30 year period. The light grey area is the extra interest accrued from compounding. The dark grey area is the principal amount, which remains unchanged throughout the life of the investment.





More is more

Because your super is typically taxed at 15%, investing some of your (pre-tax) salary into your super account (salary sacrifice) is a great, tax-effective way of putting compounding to good use. It compares favourably to investing in the residential property market where mortgages are typically paid after tax.

At current interest rates, average super fund performance has generally outpaced average house price growth1. So, given its tax advantages, super is a good complement to owning your own home in retirement through long-term investment and boosted earnings from compounding.

We can take inspiration from legendary investor, Warren Buffet, who said, "My wealth has come from a combination of living in America, some lucky genes, and compound interest”. Who could argue with the great man?

 

There are lots of options for you to explore at VicSuper to help you compound your super investment and get a better return over the long-term:

Learn more about our advice services, go to advice.

 

Important information

This advice has been prepared without taking into account your objectives, financial situation or needs. You should therefore consider the appropriateness of the advice in light of your individual circumstances before acting on the advice. You should also obtain and consider a copy of the relevant Product Disclosure Statement available at www.vicsuper.com.au before making any decisions. VicSuper Pty Ltd ABN 69 087 619 412, AFSL 237333, Trustee of Victorian Superannuation Fund ABN 85 977 964 496.

1The MySuper Growth median return for 10 years to 28/2/19 was around 9% p.a. versus the Core Logic 5 City Capital City Aggregate year-on-year return of around 8%.

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