Giving the gift of compound interest

February 11, 2014

The first lesson most young children learn about money is what they can spend it on – lollies, games, the latest toy – but it’s a parent’s obligation to also teach them about managing their money. And the earlier we can teach them about the power of compounding, the more they will appreciate us.

Compounding can be the road to riches and anyone can do it. All you need is perseverance to stay on the savings path and the intelligence to understand what is happening. Basically, compounding is earning interest on your interest. The more money you accumulate the larger the return each year.

Sadly there are two catches. First, it involves sacrifice – you can’t spend it and still save it. And second, it sounds boring – at least it is until the money starts pouring in and then it becomes downright fascinating!

Let’s look at an example.

David started a savings program at age 17 and starting with a $100 deposit. He puts away $1,500 each year for 13 years into a fund that earned 7% a year. From age 30 he didn’t add any more to his savings fund. By that time the balance of his fund was $30,450.

David’s twin sister Jenny was having too much fun at 17 spending every dollar she earned so she delayed her savings program until she reached age 30 – just when David stopped. Starting with $100 Jenny deposited $1,500 per year and maintained that amount every year until she reached age 65. Her fund also averaged 7% p.a. At age 65 Jenny ended up with $208,423. Amazingly through the power of compounding, David, who hadn’t added anything to his fund for the last 35 years has $325,123 in his account that's over $116,000 more! The 13 years that David saved were worth more than all of the 35 years that Jenny saved.

You’re probably asking, “Where would someone under 20 find $1,500?” We have a suggestion. If your adult child is working – even for a few dollars a week – they will probably qualify for the federal government’s co-contribution scheme. As well as teaching your children about compounding, you could gift them a $1,000 superannuation contribution and the government would add another $500 to their account. You could invest $1,000 over 13 years and your child could end up with more than $325,000 at age 65 (based on an average return of 7% per annum).

This suggestion applies to superannuation which they won’t be able to access until later in life, however, the principle is the same if the money is invested outside super.

There are some aggressive investment strategies available for young people who are not as risk conscious. Contact our licensed financial advisors if you are interested in finding out more.

 

Sources: Australian Tax Office website www.ato.gov.au Super co-contributions. Compund interest calculator – MoneySmart website www.moneysmart.gov.au

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