3.10 Magic of Compound Interest

This involves calculating interest for terms longer than one year. How it works is that the interest earned on the previous year is worked out and added to the amount invested. So the investor ends up receiving interest on interest already earned. See example below

Year	Principal	Interest Rate	Interest Earned	Principal + Interest
1	$900.00	7.5%	$67.50	$967.50
2	$967.50	7.5%	$72.56	$1040.06
2.5	$1040.06	7.5%	$39.00	$1079.06
10		7.5% pa		$1,855.00
20		7.5% pa		$3,823.00

Note that the Principal + Interest from the first year becomes the principal for the second year, and that the Principal + Interest from the second year becomes the Principal for the third year. Note also that to calculate the interest for half a year you use the following calculation $1040.06 (Principal) x 0.5 (Term) x 0.075 (Interest).

Investment Tip

A small amount of money over time can grow into a substantial sum.

Investments can increase in vlaue over time - and the longer the time frame, the greater the value. This is achieved through returns that are earned but not spent. Provided the return is reinvested, you earn a return on the return and a return on that return and so on. Therefore it is important to start saving early in order to benefit form the power of compunding returns.

Compounding Interest

Types of Investment Assets

Assets	Example	Risk/Return Profile
Cash/fixed interest	Term investment with ASB BANK Government Bond	Low risk, low return
Property	Direct ownership of a rental property (which can be residential or commercial) Ownership of a property trust shares/units	Medium risk, medium return
Shares	Direct ownership of individual shares such as Fisher & Paykel, Air New Zealand	High risk, high return