Compounding - the 8th Wonder of the World
by Andrew Bonnici, Senior Financial Planner
If you’ve read any basic financial literature, you may have come across the concept of Compound Interest or Compounding being referred to as 8th wonder of the world.
Why? Because if given enough time, the effects are staggering. This article will explore compounding interest and the effect it can have on your investments and future net worth.
Time Value of Money
Before we explore 'compounding' specifically, lets first touch on the concept of the 'Time Value of Money' so that we may address it’s impact during the article.
You will no doubt have noticed that $1 doesn't buy as much now as it used to. Inflation, or the general increase in the cost of goods and services, erodes the buying power of that $1.
Put simply - $1 dollar today is worth more than $1 in one year’s time. If someone offered you a $1 now as opposed to $1 in one years time you would take it now because you could buy more with it. If you waited for a year, inflation would have eroded its value.
Examples are endless; $1 worth of lollies when you were a kid seemed like a feast, today not so much. Ask you parents what they paid for the family home originally and what it’s worth now? Unbelievable. The relentless upward march of its value is staggering.
Compounding
Compounding simply refers to generating a return on a return, or earning interest on interest. In poker terms, it’s called ‘letting it ride.’
The formula for compounding is as follows; Fv = Pv (1 +i)n
Where:
Fv is future value of an amount
Pv is present value of an amount
I is the interest rate earned
n is the number amount of time periods the amount will compound
A simple example; $1000 invested in a bank account paying 9 % interest per annum invested for one year:
Fv = 1000(1.09)1 = $1090
If that amount remained invested, the following year’s return would be:
Fv = 1090(1.09)1 = $1188.1
If the investment was held for ten years, the original $1000 would then be worth $2367.
The thing to take out of the example is that the first year’s return was $90, while the second year’s return was $98. The third year’s increase was $106, and so forth. The rate of return is exponential - it gets larger the longer it is held.
Property: A Real Life Example
Let’s look at how compounding interest will affect a property investment. Depending on the research, we assume the long term average growth rate for residential property is between 7-9 per cent per annum. Let’s use an example to see what we might expect from the 8th Wonder of the World.
Mary, a 40 year old investor, buys an investment property for $400,000. She intends to hold it for at least 20 years, or at least until she retires. It increases in value by 7 per cent per annum. She borrows the full amount. What will Mary’s property be worth in 20 years time?
Fv = PV(1+i)n
= 400000(1.07)20
= $1,547,873.79
It sounds too far fetched to be true. How can a $400,000 property be worth $1.5m in twenty years? Think back to what your parent’s house was worth when you were growing up compared to what it’s worth now.
We shouldn’t forget the rent generated by that property is also increasing each year to the affects of compounding. Assuming a $350pw rent, which increases in line with inflation, we can expect $632 per week in 20 years time.
Property as a Hedge Against Inflation
The time value of money should be included in our example to find out what Mary’s property is really worth.
If we accept that the Reserve Bank kept inflation to 3 per cent per annum for the next 20 years, then the original $400,000 Mary paid for the property would be equivalent to $722,444 in 20 years time.
Mary’s investment has acted as a hedge against inflation. Mary is better off, in real terms, by $825,429 (end value $1,547,873 less $722,444). That extra amount could be added to Mary’s superannuation to help her generate a better income stream in retirement. An extra $825,429 means Mary can take out an extra $80,000 a year for ten years when she first retires and evidently needs it most. For Mary, this could be a couple of holidays every year, a restaurant every few weeks, a theatre show every few months, and so forth.
How Compounding and the Time Value of Money affects the value of your loan.
We have seen the affects of compounding on the value of Mary’s property, now let us examine its affect on any debt Mary incurred when buying the property. Lets assume Mary borrowed $400,000 using an interest only loan and has not made any capital repayments.
We know the original $400,000 is worth $722,444 twenty years later. However, the nominal or dollar value has not increased inline with inflation. Mary still owes $400,000 even though its purchasing power has eroded considerably. If we transpose the formula we see that:
PV = FV/(1+i)n
= or 400000/(1.07)20
= $103359.
Yes that right. The original $400,000 Mary borrowed is actually only worth $103,359 in 20 years time. This is to Mary’s advantage and actually works against the lender (although, bear in mind they have been charging you interest along the way).
How Compounding has Helped Mary’s Property Investment
Mary has benefited from compounding in several ways
- The Nominal or Dollar Value of Mary’s property has increased;
- The property’s Real Value has increased, i.e. it has beaten inflation;
- The rental return has kept up with or beaten inflation; and
- The amount Mary has to pay back in Real Terms has decreased.
Some Perspective
I have used property as an example, however compounding also applies to shares and cash. The benefit of compounding is no secret, the government has long realised these benefits, and this explains their focus on superannuation. They want people to be working and saving for as long as possible to generate as large a nest egg as possible. This is why it is so difficult to tap into your superannuation.
The simple most basic advice you can heed is to buy an asset and hold it for as long as possible. Let the 8th Wonder of the World work for you!
It’s important you always remember Financial Success for almost every individual comes about through long term investments. It doesn’t come about through work, nor through speculating, nor through trading assets. And those investments will be successful primarily because of compounding. That’s what will ensure you become Financially Independent and Be Financially Well.
For more information, or to arrange an appointment with a John Hopkins Financial Adviser, please contact our Client Liaison Officer on 1300 726 082 or click here.