The famous 20th century physicist Albert Einstein once called compound interest 'the greatest mathematical discovery of all time'. A catalyst in both wealth creation and spiraling debt; the following tips from Sbusiso Kumalo, Head of Channel Marketing at Capitec Bank, help explain the concept and show you how you can use it to your benefit...

What is compound interest?

There are two types of interest you can earn on an investment’s initial capital.

1. Simple interest is the interest earned on the original amount.

2. Compound interest is the interest earned on the original amount invested as well as on the interest already earned (i.e. interest on interest).

Why is it important?

"It’s good to understand how compound interest works when it comes to choosing a savings plan, because in addition to factors such as affordability, accessibility and simplicity, you will need to consider the rate of interest on offer," explains Kumalo.

Choosing between a lower or higher interest rate usually depends on whether you are interested in a short- or long-term investment. Normal banking practise is to compound interest monthly, based on actual daily balances. It is important to find out how a product works to help comparison.

Accounts offering simple interest usually offer a higher yearly interest rate and are best suited if you’re looking to save for something like a holiday or wedding and therefore want to remove the money after a year or two. However, if you are happy to invest your money for a longer period of time, you could make more money in the long-term with a lower but compounded interest rate. These rates can be compared directly if you know what the annual effective rates are.

It’s never too early to invest

The earlier you start saving, the more time you’ll have for compound interest to take effect. Consider this: Someone who invests R100 a month from age 20 to 29 and lets their investments grow, is likely to have more money at 60 than someone who invests R100 a month from age 30 to 59. So, a good time to start saving is when you receive your first salary.

Size doesn’t count

As with all financial goals, the first step is to take a realistic look at your current spending pattern and see where you can afford to cut corners and which everyday luxuries you can do without. "Think about it this way: if you save R100 a month for 40 years with a compound annual effective interest rate of 12 percent, you will end up withR970 000.

"It’s also important to be aware of fees, because on small amounts the fees can exceed the interest and your money may become less. For example, at seven percent interest your balance must exceed R700 to cover a monthly fee of R4. If, however, your monthly fee is R15 per month, your money will become less unless you have saved at least R2600," says Kumalo.

Go to page two for the rest of this article, including 'The Rule of 72' as well as compound interest and debt...

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