Compound interest

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 great returns, but things can get confusing too.

According to Neil Thompson, Product Manager at African Bank, it’s up to service providers to make sure customers fully understand how their interest-bearing products work and what numbers to consider when comparing services.

Typically, suppliers 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 looks at compound interest on one year – with a “maturity” or “maturity” rate, which takes into account the compound interest received on the total duration of the deposit.

To illustrate the difference, the bank manager looked at the example of a 10.5% rate for a 5-year fixed-term deposit. This is the annual compound rate that you will earn if you decide to pay interest each year.

Put simply, if you were to invest 100,000 Rand 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 again on June 30, 2020, June 30. 2021, and June 30, 2022, and return the principal, along with the 5th year interest on June 30, 2023, paying a total of Rand 110,500 on that date.

In total, you earn and receive interest of 52,500 rand (5 x 10,500 rand).

Annual compound interest

Year Open Interest 10.5% per year Paid close
Year 1 100,000 R R10 500 R10 500 100,000 R
Year 2 100,000 R R10 500 R10 500 100,000 R
Year 3 100,000 R R10 500 R10 500 100,000 R
Year 4 100,000 R R10 500 R10 500 100,000 R
Year 5 100,000 R R10 500 R110 500 R0
Total R52,500 R152,500

However, looking at the expiration rate, this is a higher rate that is earned by do not ask your bank to pay you interest on an annual basis, corn have interest paid at maturity of the product after 5 years.

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

“The reason is the membership – or the fact of earning interest on interest,” Thompson said.

“When we don’t get the bank to pay our interest, it is effectively reinvested and again earning interest at the annual compound rate. In this scenario, the customer 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 maturity / at maturity

Year Open Interest 10.5% per year Paid close
Year 1 100,000 R 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 look at the following:

  • Always make sure that you are comparing the same rates on the products – that is, the annual interest rates, not the expiration interest rate. If you are not sure, give them a call and ask 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 allow it to accumulate for as long as possible to get the best return.
  • You should always invest with a reputable service provider. Remember, if the rate is too high, you might not be comparing apples to apples.
  • If possible, don’t withdraw your interest. Reinvest your interest to get the most money back – to earn interest on interest, that is, 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 out of it
  • If you want to take full advantage of compounding, you need to make sure you compare the same expiration rates, also sometimes called expiration rates, for the same maturities across all banks.

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

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