Why compound interest is just like building a snowman

Unless you’re a Nobel Prize winning economist, it’s fairly likely that the first time you made a snowman you weren’t thinking about what a good metaphor it is for compound interest.

We all know how to build a snowman. You start with as much snow as your small, gloved hands can handle. You bunch it all together into a neat little ball, then push it out into the world. As you roll it around a bit, it gathers more snow, and soon enough, your little snowball will be big enough to use for something far grander – like a snowman.

Sounds fun right?

Now imagine that clumsy but hopeful little snowball is a pocket of savings. Push it out into the world, and watch as it grows in tiny increments until it becomes something much bigger.

That, in a nutshell, is compound interest.

When it comes to working this theory into your superannuation, you can see how even the smallest contributions now could add up in the long term to become something of real value later on.

If you put money away early on (that’s in your 20s, Gen Yers), either through salary sacrificing or voluntary contributions, it potentially has a much longer period to roll around, collecting interest over time.

Say you’re given an average 5 per cent interest rate by your superannuation fund. Even a snowball of $1,000 will accrue $50 gross interest in one year. The next year, the interest will be calculated based on the original investment plus the previous year’s interest. That means your interest begins to earn its own interest within just 12 months.

Getting started in your 20s – rather than your 30s or 40s – potentially gives your interest more time to create more interest. This essentially means that if one person in their 20s put away the same amount each week as someone in their 30s, the early starter could see significantly more long-term financial benefit if they retired at the same age.

To really put this theory into practice, have a play with a compound interest calculator. It’s great if you already have some savings set aside to see what they might look like in a few years, a decade, or a lifetime.

One important thing to remember is the more often interest is paid on top of your principal investment, the faster it could grow. This means that investments with paid quarterly options will generally grow more quickly than those that pay annually, or at maturity.

The ‘Rule of 72’ is a common way of determining how your interest will grow. If you divide your interest rate by 72, the result will tell you how long it will take to double your savings without making any additional payments.

For example, if you have a 5 per cent interest rate, you can divide 72 by 5 to get 14.4. This means it will take around 14.4 years for your principal to double if the interest rate stayed the same over the period. Somewhat slower than building a snowman for sure, but with little work involved in a game of double or double (rather than double or nothing), it’s a tough idea to ignore.

It is important to remember that investment returns will vary over time and not always be positive.  Also just because an investment has performed well previously, doesn’t mean it will in the future.

Find out how to put compound interest to work for you. Are you taking advantage of compound interest?