How to get the most out of compound interest – and one thing to watch out for

Compound interest is a buzzword many financial advisors mention when clients are looking to get the most out of their savings, with many financial products promising excellent returns – but things can get confusing too.

According to Neil Thompson, product manager at African Bank, it is up to service providers to ensure that customers fully understand how their interest-bearing products work and what numbers to consider when comparing services.

Typically, providers advertise the annual composition interest rate on their offers – the interest you earn as a depositor if you leave your deposit in the bank for a full year and only draw interest at the end of that year.

However, Thompson said it’s easy to confuse this rate – which accounts for compound interest on one year – with a “maturity” or “maturity” rate, which takes into account the compound interest earned on the the entire duration of the deposit.

To illustrate the difference, the bank manager took the example of a rate of 10.5% for a 5-year fixed term deposit. This is the annual compound rate you will earn if you choose to charge interest annually.

Put simply, if you were to invest R100,000 in this 5-year fixed term product on July 1, 2018, the bank would pay you R10,500 in interest on June 30, 2019, and then again on June 30, 2020, June 30 2021, and June 30, 2022, and return the principal, plus interest for the 5th year on June 30, 2023, paying a total of R110,500 on that date.

In total, you earn and receive interest of R52,500 (5 x R10,500).

Annual compound interest

Year To open Interest 10.5% per annum Paid close
Year 1 R100,000 R10,500 R10,500 R100,000
Year 2 R100,000 R10,500 R10,500 R100,000
Year 3 R100,000 R10,500 R10,500 R100,000
Year 4 R100,000 R10,500 R10,500 R100,000
Year 5 R100,000 R10,500 R110 500 R0
Total R52,500 R152,500

However, looking at the expiration ratethis is a higher rate that is earned by not asking your bank to pay you interest on an annual basisbut have the interest paid when due of the product after 5 years.

You may be thinking that the same R52,500 as above will be paid out after 5 years, which together with the repayment of the initial capital would result in a total payment of R152,500 on June 30, 2023 – however, the reality is that the total payment will be much higher.

“The reason for that is compounding — or earning interest on interest,” Thompson said.

“When our interest is not paid by the bank, it is effectively reinvested and again earning interest at the compound annual rate. In this scenario, the client earns an additional amount of over R12,000, which translates to a total interest earned of over R64,000 at an “expiration rate” of 12.95%. »

Annual compound interest at expiration/maturity

Year To open Interest 10.5% per annum Paid close
Year 1 R100,000 R10,500 R0 R110,500
Year 2 R110,500 R11 603 R0 R122 103
Year 3 R122 103 R12 821 R0 R134 923
Year 4 R134 923 R14 167 R0 R149 090
Year 5 R149 090 R15,654 R164 745 R0
Total R64 745 R164 745

According to Thompson, to get the most out of compound interest, you should consider the following:

  • Always make sure to compare the same rates on the products, i.e. the annual interest rates and not the interest rate at expiry. If you are unsure, call and ask them or visit your local branch.
  • Also remember that a monthly compound rate is lower than an annual compound rate. It’s always best to leave your interest in the bank and let it accumulate for as long as possible to get the best return.
  • You should always invest with a reputable service provider. Remember that if the rate is too high, you may not be comparing apples to apples.
  • If possible, do not withdraw your interest. Reinvest your interest to get the most money back – to earn interest on interest, aka compound interest.
  • Always check if you will pay penalties if you withdraw your deposit early and/or what you can withdraw when.
  • Invest as long as possible to get the most benefits
  • If you want to take full advantage of the compounding impact, you need to make sure that you are comparing the same expiry rates, also sometimes called maturity rates, for the same maturities across all banks.

“Don’t forget to shop around and make the necessary comparisons. Don’t be afraid to ask questions and make sure you fully understand the interest you will earn,” he said.

Read: How much you could earn in a tax-free investment account over 2, 4 and 10 years

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