Question 6
Question 6: I have been told to start saving/investing early due to the effect of compound interest. Could you please explain this concept to me?
A.
Effect of compounding overtime:
Compounding is the ability of an investment or a loan to generate interest or earnings. Compounding is referred to generating earnings from previous earnings. For example, if you were to invest $10,000 into a term deposit that compounds annually by 20%, after the first year your investment would be worth $12,000 ($10,000*1.2%). In the second year with 20% compounding annually, your investmend would be worth $14,400 ($12,000*1.2). Rather than your investment appreciating by an addition $2000 (20%) like it did in the first year, it appreciated by an additional $2400 as the $2000 gained in the first year grew by 20% as well. If you were to investigate the process, the numbers can beging to get very big as your previous earnings start to provide returns. Therefore it is important to start saving/investing early as the effect of compounding would benefit you if you were to invest earlier than later.
Affect of compound interest vs. simple interest:
(Source: Accounting Concepts and Applications 4th edition, Phillipa Greig, Joan Mackay, Stacey Beaumont, Rosette Sanger, 2008)
