The Beauty of Compound Interest

As always, the content below is meant as general information to give you a better understanding of this topic, and is subject to our terms and conditions. You should seek appropriate personalised financial advice from a qualified professional to suit your individual circumstances.

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So, compound Interest. Never heard of it? Fair enough. The purpose of this blog is to:

1. Explain what compound interest is

2. Help you understand why it is so valuable, so that hopefully you can take advantage of its key benefits, and make it a part of your long-term financial future

First, let’s cover off “interest” - this is the ‘fee’ you either pay (when you borrow money) or receive (when you loan money). It’s almost always calculated as a % of the amount borrowed, per year. So if you borrowed $100,000 at a rate of 4% - you would pay $4,000 of interest per year.

Many people don’t realise that when leaving money in their bank account, they are effectively ‘loaning’ that money to the bank. In return, they receive interest. Sometimes it’s not that much, which is why it pays to check the level of interest paid on your savings and everyday accounts.

There are other ways to earn interest, for example term deposits.

Compound interest is pretty simple. Each time you are paid interest, just leave it in the account. Don’t withdraw it, don’t spend it, just leave it. Then, the next time you are paid interest, you’ll be earning interest on your interest. 

Albert Einstein called compound interest “the eighth wonder of the world.” - Okay, so that’s quite extreme, but it is pretty amazing.
Let’s say you have $1,000 in the bank earning 4% interest per year. By the end of the year, you will have received $40 of interest, and will then have $1,040 sitting in your account. The following year (as long as you haven’t withdrawn the money), the 4% of interest will be calculated on the new amount (the $1,040) - not the $1,000.

So, at the end of year 2, you will have $1,081.60 in the account - you received $41.60 of interest, instead of the $40. You earned interest on your interest.
This might not sound like much. It’s not even enough for a flat white. But let’s fast forward 10, 20, 30 and even 40 years. Compound interest shines the longer you leave it.

Example 1: Compound interest (4% per year) with a $1,000 initial deposit and no regular deposits.

Source: Money Smart Compound Interest Calculator

Example 2: Compound interest (4% per year) with $1,000 initial deposit and $20 regular deposits each week.

Source - Money Smart Compound Interest Calculator

How to make the most of compound interest

1. Start early, save regularly – Save small amounts often. As shown above, saving as little as $20 a week can create a very nice nest egg thanks to compounding interest. A lot of the time, saving small amounts earlier in life will have a greater impact than saving larger amounts later on.

2. Check the interest rates on your bank accounts –  A survey* shows that around 62% of Kiwis use their savings account as their primary investment strategy. That’s okay, but it means we should be paying extra attention to the details - e.g. the interest rate and how often it’s compounding (generally speaking, the more frequent compounding, the better).

 A cheque or ‘everyday’ account linked to your Eftpos card typically earns no interest. If you’re keen to start saving, have a look at your bank's website to see what kinds of savings accounts are available, and at what interest rate. You can check out what you bank is offering and compare to others in the market here: https://www.interest.co.nz/saving/call-account 

3. Get excited about the numbers!
So maybe numbers aren’t the most exciting thing. But the rule of 72 is an easy tool you can use to figure out how your savings or investments can grow with compound interest. Simply divide the number 72 by the interest rate. The answer shows how many years it will take for your money to double.

o   E.g. if you have $5,000 earning 4% (after tax). 72 divided by 4 = 18 years.

o   Every 18 years, your money will double.

There’s a handy tool you can use to see what your money may look like in the years to come: Compound Interest Calculator

Compound interest on our debt

Unfortunately, compounding interest can work against us as well, making it more difficult to pay off debt. The longer it takes us to repay debt that charges interest, the more we ultimately end up paying.

If you do have debt such as credit cards or pay day loans, compound interest can work against you. To work out how much you will pay over the lifetime of the loan, check out this debt calculator.

So, there you have it. A bit of an explanation about compound interest and you can use it in your long-term financial planning. 

If you have any questions, please get in touch with us - We would love to hear from you. 

I have no assets, so why would I need a Will?

The short answer:

You probably do have assets, and just don’t realise it. If you die without a Will, you’re leaving a legal mess behind for your family to deal with. It doesn’t take very long to sort out and could save your loved ones added hardship in the event of your death.

The slightly longer answer:

A Will is basically a piece of paper detailing what you want to happen to everything you own in the event of your death.

Many people think they don’t have assets, but your car, your KiwiSaver money, cash savings, and anything else of value, all need to be dealt with.

If you die without a Will, it is called dying ‘intestate’. In this case, the court can freeze all your assets for 6 months or more. This can be a major hassle (and cost) for your family during an already difficult time.

In this scenario, the court decides how your stuff is divided up - using a standard formula. A lot of people are under the impression that if they died today, their family or spouse would be able to sort everything out easily. Unfortunately, that just isn’t the case.

People don’t like to talk about death, and we totally understand. But, getting it sorted now could mean a lot less complication for your loved ones in the future.
 

What is a Financial Adviser and why should I use one?

A lot of Kiwis would like to get some good financial advice, but don’t know where to start, or what to look for.

In a nutshell, a Financial Adviser is one point of contact, who knows all the financial stuff, inside and out.

They’re independent, registered, and work with lots of Insurance Companies, Lawyers, Accountants etc to make sure your ducks are in a row.

Your Adviser is like your own personal ‘fixer’. If something changes in your life (like a new job, new kids or buying a house, they’ll help you sort your Insurances, KiwiSaver, Mortgage, Legal Documentation etc so it continues to meet your needs through life.

One of the most important things your Financial Adviser can do, is go to bat for you if you need to make an Insurance claim. They deal directly with the Insurance Company to make sure they pay out.

There’s only a few thousand Independent Financial Advisers in New Zealand, and they’re busy as bees working to looking after their clients. We can tell you wholeheartedly, our Advisers at Solutions (our sister company), are fiercely passionate about helping Kiwis succeed in life financially.

Some Financial Advisers will charge you a fee for their work (mainly in the investment space), while many others offer their services free of charge (they are usually paid a fee directly by the financial institutions, such as the Insurance Company or KiwiSaver provider, to look after you).

They say there’s no time like the present, and Covid-19 has certainly shaken us all this year. This has highlighted the need for Kiwis to have good financial resilience for when the unexpected happens – This is exactly what Financial Advisers are there to help you with.

“New Zealanders who get financial advice on average have KiwiSaver balances over 50% bigger than those who don’t; are more likely to have insurance cover; and have greater peace of mind and confidence in making financial decisions.” - Money & You NZ

We deal with people from all walks of life – Trades people, Small business owners, Medical Professionals, Farmers, Teachers, CEO’s and Directors – The list goes on. It doesn’t matter who you are, what you do, or how much you earn, you can always benefit from having a good Financial Adviser look after you.

Get in touch, and we can have a quick chat about how we can help you.

"I earn more than I used to, but it feels like I have less money."

If this sounds like you, don't feel bad. It's a really common situation that most of us have experienced, and usually we aren't even aware of what we're doing to cause it.

First things first, we know life happens. Unexpected bills and greater responsibilities can mean more spending. What we've written below refers more to the extras, the things we don't need to spend money on.

So, there's this thing called Parkinson's law. Without getting too far into it, the law says that "Work expands so as to fill the time available for its completion." This basically means it doesn't matter how long you give yourself to complete a task, 1 day, 1 week, a month - whatever time limit you set, that's how long it will take.

This law seems to apply to other things, too. The bigger our house, the more stuff we'll accumulate to fill it up. The bigger our plate, the more food we'll pack it with, and subsequently eat.

In a financial context, the more money we have, the more we seem to find things to spend it on. Living our entire lives like this means we'll probably never get ahead financially, and will live our lives paycheque to paycheque.

So why do we spend more when we earn more?

Essentially it comes down to our relationship with money, and our lack of transparency over where it goes.

Us and money.

Let's say you get a new job and go from receiving $650 cash into your bank account each week to $900. Fantastic. Now, there are a couple of legitimate expenses that might come with that. Maybe the job is further away, so transport costs a bit more - or you might need to upgrade your wardrobe. But fundamentally, there is no reason you shouldn't be able to save at least $200 extra per week than you were before. It's just... you probably won't.

Now don't get us wrong, we're guilty of this too. See, the issue is in our thinking. As soon as we hear the words "pay rise" many of us start making a mental list of all the great things we can now afford. This might seem okay to get us to a certain "level" of comfort - but the problem is, it never stops. There will always be something to upgrade, something better than what we currently have. Unless we change our thinking, it doesn't matter how much more we earn, we'll continue to spend all that extra money - and never reach our financial goals.

The transparency thing.

"You really should have a budget" - we hear this often. But it's so important that we're aware of where our money is going each week, each month - instead of pay-waving our way through life without a care in the world.

A budget is essential, and we have a great tool for you a little later in this blog.

 

There are a few other things that trap us in to overspending

- Online lay-buy services

- Hire Purchases

- Apple bringing out a shiny new iPhone that no one actually needs

- Qualifying for higher levels of debt, such as a credit card or big mortgage. A bank or financial institution being willing to loan you money, doesn't necessarily mean you should take it.

How do we stop it?

1. Look at all your spending from the last 2-3 months. That is, take a good hard look at your spending. What is essential, what isn't? Do you remember when you used to live of $300 a week? What are you doing differently now? We're not saying live off bread and water, but be practical about what you need vs. what you want.

And one thing, don't discount something from your analysis as a "one-off" big purchase, like a holiday. Because chances are, you'll have more of these coming up. You're better off accounting for ALL your spending, and then making a "holiday fund" bank account where you put a set amount aside each week.

2. The best way to break that annoying Parkinson's law? Limit your spending. The only way: Make a budget, and stick to it. We know, you hear it all the time. But there's a reason for that. It makes you cut the crap, and become accountable for where your money is going. Sorted.org has a really good budgeting tool you can find here. Go make one, and set yourself a goal of sticking to it for 8 weeks. See how you go.

3. Talk to a financial adviser. We say this a lot too, but their help is free, and they often have some really good ideas. For example, if you have a mortgage and a decent amount of credit card debt, they might suggest you move the credit card debt (on which you're probably paying interest of over 18%) and turn it into mortgage debt (which is probably somewhere around the 4.5-6% mark).

There it is. A brief explanation of why we often find ourselves with less, when we're earning more - and a few practical steps to help you get past it. If you have any more questions, please just get in touch.