How to get the most out of compound interest – and one thing to watch out for

Compound interest is a buzzword that 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 also get confusing.

According to Neil Thompson, head of product at African Bank, it is up to service providers to make sure customers full understand how their interest-bearing products work, and which numbers to look at when comparing services.

Generally, providers advertise the annual compounding interest rate on their offerings – the interest you earn as a depositor if you leave your deposit with the bank for a full year and only draw the interest at the end of that year.

However, Thompson said it is easy to confuse this rate – which looks at compound interest over one year – with a ‘maturity’ or ‘expiry’ rate, which takes into account the compound interest earned over the entire deposit term.

To illustrate the difference, the banking head looked at an example of a 10.5% rate for a fixed term deposit of 5 years. That is the annual compounding rate that you will earn if you decide to have interest paid out annually.

Simply put, if you were to invest R100,000 in this 5-year fixed term product on 1 July 2018, the bank would pay you R10,500 in interest on 30 June 2019, and again on 30 June 2020, 30 June 2021, and 30 June 2022, and return the principle, together with the 5th year’s interest on 30 June 2023, paying out a total of R110,500 on that date.

In total you earn and are paid out interest of R52,500 (5 x R10 500).

Annual Compounding Interest

Year Open Interest 10.5% per annum Paid out Close
Year 1 R100 000 R10 500 R10 500 R100 000
Year 2 R100 000 R10 500 R10 500 R100 000
Year 3 R100 000 R10 500 R10 500 R100 000
Year 4 R100 000 R10 500 R10 500 R100 000
Year 5 R100 000 R10 500 R110 500 R0
Total R52 500 R152 500

However, looking at the expiry rate, this is a higher rate that is earned by not having your bank pay you the interest on an annual basis, but by having the interest paid out on maturity of the product after 5 years.

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

“The reason for this is compounding – or earning interest on interest,” Thompson said.

“When we don’t have our interest paid out by the bank, it is effectively re-invested and earns interest again at the annual compounding rate. Under this scenario the customer earns an additional amount of over R12,000, resulting in total interest earned of over R64,000 at an ‘expiry rate’ of 12.95%.”

Annual Compounding Interest at Expiry/Maturity

Year Open Interest 10.5% per annum Paid out Close
Year 1 R100 000 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 be sure you are comparing the same rates on products – ie the annual interest rates, and not the expiry rate interest rate. If you are not sure, phone and ask them or visit your local branch.
  • Also remember a monthly compounding rate is less than an annual compounding rate. It is always better to leave your interest in the bank and let it accumulate for as long as possible to receive the greatest return.
  • You should always invest with a reputable service provider. Remember if the rate is too high, you may not be comparing apples with apples.
  • If possible don’t withdraw your interest. Reinvest your interest to get the most money back – to earn interest on interest, i.e. compound interest.
  • Always check if you will pay penalties if you withdraw your deposit early and/or what you can withdraw when.
  • Invest for as long a period as possible to receive maximum benefit
  • If you want the full impact of compounding you need to ensure you are comparing the same Expiry Rates, also sometime referred to as maturity 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 be earning,” he said.

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

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How to get the most out of compound interest – and one thing to watch out for