The importance of compound interest for your savings

In matter savings, investment and wealth, everyone is looking for ways to increase their capital, or even double it as quickly as possible. One of the best ways to do this is to exploit the effect of compound interest.

Declared “eighth wonder of the world” by none other than Albert Einstein, compound interest has a significant positive impact on your savings. So if you know how to use this strategy well, it can grow your savings, consistently and exponentially.

But what exactly is this concept and how can you benefit from it?

It is essential for all investors to be familiar with this concept, whether you are a professional, self-employed or about to retire. Thus, through this article, our expert advisors in the field share with you their in-depth knowledge of this often underestimated reality which nevertheless has a great influence on the creation of long-term wealth.

Let's start with the basics.

What is the principle of compound interest?

Essentially, compound interest is a calculation in which interest earned on an investment is capitalized. This interest is therefore added to the initial capital and contributes to the accumulation of new interest. As it does not withdraw and the interest received, the investor increases the amount of capital on which interest is calculated for the following period. Thus, the interest received year after year becomes higher than that of the previous period.

This compound interest “snowball” mechanism proves particularly effective over a long period. The benefits of compound interest can be appreciated over the medium to long term and ensure that your wealth increases when investment returns are constantly reinvested.  

If we take a 15-year example, a compound interest investment of 1% will produce a total cumulative return of 16.1%. If the investment yields 2% it will have a cumulative return of 34.6%, more than double the 16.1%. If the investment is made at 5% per year, the capital will have increased by 107.9%, more than a doubling.

We therefore see that the savings formula chosen for the very long term produces very different results depending on the return obtained.  

It is of course clear that getting a return of 5% (on average) involves taking much more risk than getting a return of 1%. You must therefore carefully analyze your ability to take risks and "hold on" over time.  

Indeed, over long periods (10 years and more) stocks offer more attractive returns than bonds or savings accounts. This, however, implies that the saver will be able to weather market shocks, because going from their investment to the lowest level has devastating consequences on this approach

Our recommendation

Most Swiss households deposit their retirement savings into a savings account at the bank. In the case of their pension fund, they also choose a rather defensive approach, when several management profiles are offered. This also applies to saving in 3a accounts which offer tax advantages.

Since the economy has experienced low interest rates on savings, the effect of compound interest earned is currently relatively small. In the long run, your money stagnates in the savings account and continues to lose its value. Additionally, for private savings, income taxation and wealth tax contribute to further eroding capital.  

Investors must therefore use investment solutions to benefit from the capitalization effect on a much larger scale. You will then automatically benefit from the effect of compound interest since many investment products ensure continuous reinvestment of income.

It is possible to obtain additional returns by combining the income (interest and dividends) obtained by investment solutions available on the financial market, such as:

• bonds,
• actions,
• mutual funds and
• funds that replicate stock indices (ETFs).

Although these investments carry their share of known risks, the effect of compound interest from stock market investments is particularly significant in the long term.

By regularly putting money aside in one of these investment products for several years, the capital invested grows more and more strongly over time. In principle, the earlier you start investing for the long term, the more the gains with this approach increase.

If you regularly contribute to a 3a bank account, securities investment has proven its effectiveness. Impact FE experts will help you develop a complete low-cost investment solution that reinvests interest and dividends. Our specialists will also work with you to establish one financial plan which will maximize tax benefits so you can reap the benefits of your investments in the long term.

Here is a table showing an example of the effect of compound interest on your stock market savings compared to saving in a bank account.

How does the compound interest effect work?

To better understand the concept of compound interest, we offer you an example.

At the age of 25, François began working. After a year, he managed to save CHF 5,000. He decides to invest his money in an investment because the interest rate on the savings account is too low. Assuming, the fund generates a return of 5% per year and therefore, at the end of the year, its capital increased by CHF 250. Now, its total capital is CHF 5,250. He decides not to withdraw this amount.  

Compound interest begins to produce its effects from the second year. In the second year, the interest rate is applied to all assets (including credited income) to calculate the return on the investment: CHF 5,250. A return of 5% on this investment in the second year translates into a total return of CHF 262.50, or CHF 12.50 more than the previous year, which is compound interest. After 2 years, François' capital increased to CHF 5,512.50.

After 40 years, its investment of CHF 33,523.76 will amount to CHF 35,199.94, representing total interest of CHF 1,676.19 at a rate of 5% per year.

As you can see, invested capital increases exponentially as returns are reinvested or capitalized.

How to calculate compound interest?

Although this way of generating interest is relatively common, most investors do not use it because they find it complicated. With this formula, it becomes extremely easy to calculate the compound interest you can earn in a given number of years.

A = P(1+ r/n) t

In this formula:

• A represents the future value (of the investment),
• P designates the principal (initial amount invested),
• r indicates the interest rate,
• n constitutes the number of composition periods and
• t represents the duration of the investment (in years).

Good to know

Depending on the situation, compound interest can have a positive or negative effect. As an investor, compound interest generated on your capital has a positive financial impact. However, in the rare case of a borrower who falls into over-indebtedness and borrows money to finance the interest expense of another loan, the compound effect may work against you.

Some financial organizations charge interest on the amount initially borrowed, as well as on the amount of accrued interest expense.  

Last words

Compound interest is a long-term game. We therefore advise all our clients to start investing as soon as they start to benefit from a stable and regular income. So what matters is to start early.

When considering investments, consider all the determining factors. Your choice of investment options should be made after careful consideration of all the risks involved. Choose products that match your investor profile and risk tolerance. It is not wise to invest in riskier funds if you only plan to use them in the short term.  

With long-term investment discipline, you will avoid any financial problems in the near future.

For a transparent discussion about investment options and the risks involved, take an advisory interview with one of our knowledgeable retirement savings and tax benefits advisors at Impact FE.