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Simple interest vs Compound interest

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Simple interest vs Compound interest

Compound interest is like dreadlocks

Ever wondered why dreadlocks grow longer and thicker than loose natural hair? The extraordinary growth and length of healthy dreadlocks mimics the power of compounding as seen in finance.

When we comb or brush our hair, we lose some in the process; this is known as hair shedding. Shedding is part of the normal process in the science of hair growth.  Whether you have “normal” loose hair or dreadlocks, you will experience some level of hair shedding. For those of us with loose hair, we usually dispose of excess hair that gets stuck on the brush, however, if you have dreadlocks, most of the shed hairs are not released. They in fact remain stuck to the hair lock, which helps length, retention and growth of hair.

When your hair is in dreadlocks, it is free from combing, brushing and other manipulation methods. So, as the hair grows, the shed hairs are put back into the locs and they work together to produce length in the hair’s lifecycle. Dreadlocks also benefit from higher levels of strength because the hair is combined together. When the hair is loose, it is more likely to experience relatively higher levels of breakage. This is the power of compounding.

So how does this relate to interest?

In finance, we refer to “compound interest” and “simple interest”.

When we invest money in certain financial products, we expect returns by way of interest. If you are earning simple interest on an investment, your interest is earned on your original investment only. The interest you earn is not reinvested. This is similar to loose hair – overtime, as your hair grows, the shed hairs are released (interest).

If you are earning compound interest, not only are you earning interest on your original investment but all interest earned is reinvested together with your original investment. Therefore, the power of compounding allows you to earn interest on the original as well as on the interest that has been reinvested. You get the picture – with compound interest, the excess hair is reinvested with the locks and the dreadlocks can grow infinitely long.

Let’s cement this with an example

Say you want to invest R1 000 today in an investment earning 10% interest over the next five years:

As per the figure above, the compound interest yields R1 610.51 compared to only R1 500 generated from earning simple interest. This power of compounding only gets better with time! Whether you are earning simple or compound interest, your investment is growing, but the power of compounding is infinite as new growth continues to bond and unify with the older investment – just like dreadlocks.

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