Qualified Financial Adviser Shona Chambers explains how compound interest can leave you with more than you expect.
A client of mine asked me recently ‘How can that projection report show a project fund value of €48,000 if I am saving €400 per month for five years?’ She correctly noted that €400 per month adds up to €24,000 over 5 years. I explained the nuts and bolts of how a savings policy works and I also explained about compound interest.
I told her a story about a father who decided to give both of his children a sum of money. He gave the children the choice of a lump sum of €5,000 at the end of the month, or they could have €100 per day with an interest rate of 4% per day compounding, for 30 days. One child chose the €5,000 and the other chose to take €100 per day with interest.
And I asked her the question? ‘At the end of the month, which child do you think ended up with more money?’ ‘The first child of course’ she said without hesitation. She was shocked when I told her that the second child received the most money.
Because of the power of compound interest, the second child ended up receiving €6,157.17 in total. Albert Einstein is rumoured to have called compound interest ‘the eighth wonder of the world’. And compounding is indeed a wonder, given how it can transform modest savings over time into a substantial nest egg. If someone starts saving at the age of 20, and puts €200 a month for 10 years into an investment fund, she will have nearly half a million euro in that fund by the age of 70, even if she never contributes another penny after she turns 30! This assumes an average annual return of 7%.
Even more dramatically, assume you invested the first two years of your son’s child benefit payment (€130 a month) into a fund that returned 7%. If he did not touch that money thereafter, it would be worth over €320,000 by the time he turned 70. This may seem like magic, but it really illustrates how compounding can boost the value of savings over long time periods.
Naturally, you have to consider factors such as inflation, market volatility, and taxes, all of which can affect the final value of your investments. Inflation means that the real value (or purchasing power) of money gradually falls over time, so that it will take more money in the future to buy the same goods and services. Market volatility means that your investments can be subject to unpredictable booms and busts. Savings and investments can be subject to DIRT or exit tax, which can reduce how much of your returns you get to keep.
It must be acknowledged that the current market is not the friendliest for savers. The low rates on offer for deposit accounts and increases in DIRT and exit tax rates have contributed to negative sentiment among savers. But the most important thing about saving and investing is that ‘slow and steady wins the race’. It is important to keep your eye on the bigger picture and not get distracted by current government policy or today’s economic news.
Shona Chambers is a Qualified Financial Adviser (QFA) and Retirement Planning Adviser (RPA) with John McColgan Financial Services Ltd in Letterkenny. She has worked in the financial services sector since 2003. Having earned her BA (Hons) from the National University of Ireland, Maynooth, her professional experience includes working at a number of major Dublin-based financial services firms. She is also a Certified Accounting Technician, with Accounting Technicians Ireland.
A native of Letterkenny and living in Ramelton, Shona is very actively involved in the local community. She is Vice-President of the Donegal Women in Business network, the Business Director of Junior Chamber International’s Donegal branch and a director and board member of Letterkenny Community Childcare Ltd. Shona also writes regularly in the local press.