How compound interest works and how it can change your life

Compounding is a financial concept that’ll turn your life on its head. So profound is its effect that Albert Einstein reputedly referred to compound interest as “the eighth wonder of the world”.   

How compounding works

Compounding is best thought of  as returns generated on returns. So in a savings account, it would mean earning interest on interest you’ve already earned. In the same way for a loan, it means paying interest on interest that’s been added to the outstanding loan balance.

Turning back to the savings example, let’s say you decide to start saving seriously and you put aside $1,000 from your take-home pay this month in a high-interest savings account. You don’t make any withdrawals or any contributions for 3 months. To make the compounding effect more obvious, we’ll assume an interest rate of 3% per month (please note: you aren’t going to find a savings account with an interest rate anywhere near this figure, it’s purely for illustrative purposes to make the compounding effect more obvious).

This is how compound interest would look like for your account.

Month Opening balance Interest @ 3% per month Closing balance
1 $1,000.00 $30 $1,030.00
2 $1,030.00 $30.90 $1,060.90
3 $1,060.90 $31.83 $1,092.73

Pay attention to how the interest amount is increasing every month even though you aren’t making any contributions. This is because you’re earning returns from previous returns. In month two, your 3% interest is calculated on not just the $1,000, but on $1,030 (the original amount you deposited AND the interest that had already been earned). In month three the interest gets calculated on $1,60.90, resulting in an ending balance of $1,092.73.  

Why compounding is a big deal

Investment compounding is the great leveler. Compounding doesn’t care about your gender, race, religion or sexual orientation. The maths works the same for everyone. All that matters are the size and frequency of your contributions, the rate of return and the length of time compounding is allowed to work its magic. All other things equal, the longer you compound for, the better.

The scenario we outlined  in the simplified example  above used just 3 months to illustrate the power of compound interest. When compounding is allowed to work its magic over years, not months, well…that’s when things start to get really interesting…

So let’s look at a scenario where $10,000 is available to be invested for 10 years. To keep the focus purely on the compounding effect we’ll ignore any further regular or one-off contributions.  We’ll assume that the amount invested can compound at one of three different rates of return; 1%, 3% or 5% per year.  

The chart below shows the difference in outcomes at the end of the 10 years.

At a 1% return per year the $10,000 grows to $11,046 after 10 years. That same $10,000 earning 3% per year grows to $13,439.

At 5% per year the investment ends up being worth $16,289, some 47% more than achieved with a 1% return per year. Small differences compounded for long enough add up to big differences in final outcomes.

Eagle-eyed readers would by now have recognised that no-one is getting 3%, let along 5% per year on their savings accounts, with current at call rates sitting in the 1.4% to 1.6% per year range. That’s why we chose 1% per year as our baseline scenario, being close to the long-term pre-tax real return on cash (i.e. after the effect of inflation is taken into account but before tax).  

To get better than a real return of about 1% per year you’ll need to invest outside of a bank account or term deposit. And if you do, you’ll have to be comfortable with your investment balance fluctuating from day to day.

How to make compounding work to your benefit

Saving & Investing

There are three key drivers that make compound interest your bestest pal:

  1. The rate of return – obviously the higher the better, but as noted above, the higher the prospective return the greater will be the fluctuations in value in the short term.
  2. Big contributions – make a yuge (or as yuge as possible) initial contribution, as the bigger it is the more there is for returns to compound on, and of course make further contributions on a regular basis to keep that interest compounding.
  3. Lots of time – keep your investment for as long as possible. Longer periods of time will help iron out any shorter-term volatility in returns but also extend the compounding process of earning returns on returns.

Early Debt Reduction

Compound interest can be more than just your savings bestie, it can work well for debt reduction (like your mortgage or car loan) as well.

If you pay extra on your loan repayments early on in the loan term, you can reduce your interest bill, and time to repayment, significantly. That’s because in the early stages of any loan, each repayment consists of more interest than principal, with this ratio slowly inverting over time. Any additional repayment reduce the principal outstanding, which means there’s less for the loan interest to compound on. Happy days!

How to avoid compound interest becoming your worst enemy

Mortgage

As we mentioned above with mortgages, an extra payment or two can have a positive effect on your interest total in the long run, but it can also have the opposite effect.

According to Finder, the average mortgage repayment term in Australia is 25 years. If you were to take out a $400,000 loan (the Victorian average is $387,600) at an interest rate of 5.5%, at the end of the 25 year period you will have paid a whopping $335,656.29 in interest – almost the total sum of your loan all over again. And if you miss a repayment due to unforeseen circumstances, it could take months or even years to pay that mistake off in the future.

Compound interest is a friend you’ll want on your side when you sign on the dotted line for your mortgage. And you can keep it that way with timely repayments to keep that growing interest at arm’s length.

Consumer Debt (Credit Cards/Car Loans etc)

You’re gonna wanna boot compound interest from your sleepover club when you hear what it can do to your finances.

Credit card and car loans are two types of debt that commonly have high interest rates and are most often utilised by the everyday Australian consumer.

With a credit card debt for example, you may owe a principal amount of $15,000 which accrues 10% interest every month, which means after the first month you’ll owe a total of $16,500. However, in the month after that the interest will be charged as a percentage of the $16,500 total and not $15,000, which means you can quickly end up paying more in interest than the principal amount.

In this instance, your debt is growing exponentially and compound interest has officially moved into your spare room and become your worst nightmare. Prioritise the repayment of high interest consumer debt wherever possible.  

In summary

Compounding is a force that can either work for you or against you. Astute investors know how to use it to their advantage; by starting early, saving often and aiming for a compounding rate greater than available just from a standard savings account or term deposit.  

They acknowledge that in seeking a higher overall compounding return they will need be able to hold their investments through some periods when returns may be low, or even negative. They manage risks through appropriate diversification. Then they let time do the rest.

The last word on compounding must surely go to Einstein, who is reputed to have mused: “He who understands it [compound interest], earns it. He who doesn’t, pays it.”

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