How Does 'Magical' Compound Interest Actually Work?

19 April 2018
If you’ve got money in a savings account, it’s likely to be growing due to compound interest; but what is compound interest, and how does it work?

Let’s start with a very brief explanation of interest as a concept. In the context of say, a savings account, interest is money paid to you by the bank as a reward for putting your money in their hands – it could also be considered an incentive for you to keep putting your money in their hands.

The interest that a bank pays you is directly proportional to the amount of money you have deposited with it and is determined by an interest rate which is a percentage, usually expressed per annum.

With simple interest, the interest rate is applied to the principal only. So for example, if you were earning simple interest rate of 2% p.a. and you deposited $1,000, you would see that sum grow to $1,020 if the interest is paid at the end of the year. This is the kind of interest paid on some term deposits.

So now that’s clarified, on to compound interest.

What is compound interest?

With compound interest, the interest rate is applied to both the principal and any prior interest earned; in other words, you earn interest on interest. It essentially means that your money will grow exponentially over time rather than linearly, which it would if you were earning simple interest.

For example, $1,000 earning 2% p.a compounded monthly would become $1,020.18 after the first year – this is because after the first month, the interest rate is being applied to both the principal (the $1,000), and the interest already added to the account. The compound interest paid on the principal would slowly but surely increase at a faster rate than any simple interest paid on the same principal.

The table below shows how simple and compound interest would accumulate on the same principal of $1,000 over a fifty-year period, where the interest rate is 5.0% p.a. For the simple interest, interest is earned on the principal at the beginning of the year, and paid at the end of the year. For compound interest, the interest is paid into the account monthly and the interest is earned on the monthly balance in subsequent months.

Simple interest  Compound interest $ Difference
Year 0 $1,000 $1,000 $0
Year 5 $1,250 $1,283.35 $33.35
Year 10 $1,500 $1,647.00 $147
Year 25 $2,250 $3,481.27 $1,231.27
Year 50 $3,500 $12,119.31 $8619.31

As you can see, the difference is significant – compound interest has seen the $1,000 grow to $8,619.31, whereas simple interest saw it become $3,500.

Imagine the effect that compound interest could have over an even longer period? Superannuation, which typically accumulates over a person’s working life, relies reasonably heavily on the power of compound interest in order to build up.

The following table contains details of the superannuation funds rated by Canstar formulated based on someone aged 40-49 with a balance between $100,000 and $250,000, sorted by Star Rating (highest to lowest).

Please note that the performance information shown in the table is for the investment option used by Canstar in rating of the superannuation product.

To view the past performance of all super funds, rated by Canstar, use our comparison tool:

Does compound interest have any downsides?

The one negative aspect of compound interest is that sometimes you’re the one paying it, if you have loans or other outstanding debt. The vast majority of loans and line of credit products offered by banks and credit unions, including home loans and credit cards, charge compound interest.

This can be a real issue if the loan balance increases, and credit card interest especially can be a cause for concern.

If, for whatever reason, you leave an outstanding balance on your credit card beyond the limit of the interest-free period, compound interest could see that outstanding balance get larger and larger as time goes by. And if the reason it was outstanding in the first place was that you couldn’t afford to pay it down, it becoming even larger can be a recipe for financial distress.

Compound interest is just one of the reasons why knowing what you can afford to borrow (or spend on a credit card) is crucial, because it’s great when it’s working for you but not so positive if it’s working against you!

That’s why it can be good to consider a credit card with a low rate, so any interest you do end up accruing on your balance will be as little as possible, and easier to pay off than on a card with a higher rate.

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