HomeFinanceInvestmentHow does compound interest actually work?

How does compound interest actually work?

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” ― Albert Einstein.

Einstein spent a lot of his life in debt, for all he was a genius. On the other hand, investment guru Warren Buffett famously extols compound interest as an investor’s greatest ally, attributing much of his wealth to this principle: 

“My wealth has come from a combination of living in America, some lucky genes, and compound interest”.

“That’s nice Gillian,” you’re probably thinking, “but why are you giving me a bunch of quotes about money. The answer is TikTok – or specifically a viral video that keeps cropping up claiming you can pay down your home loan in five years by spending a dollar a day. 

Spoiler here: you can’t. But it also made me realise just how misunderstood compound interest is. It’s neither good or bad, but it literally pays to understand how to use it to your advantage. So here’s my quick overview of what you need to know. 

What is compound interest?

Compound interest is the interest charged or earned on both the initial principal amount (the amount you’ve borrowed or have in your savings account) and any previously earned – or charged – interest.

  • Imagine a savings account with $1000 and a 10 per cent interest rate. 
  • After the first year, you would have $1100 ($1000 + $100 in interest). 
  • In the second year, you’d earn interest not only on the initial $1000 but also on the $100 interest earned in the first year (so, 10 per cent interest applied to your $1100 of savings), resulting in a total of $1210 ($1100 + $110 in interest).

This compounding effect continues over time. If you’ve got an interest-earning savings account, your money will grow over time. 

Now, let’s look at how this works when you have an interest-bearing debt – like your mortgage.

How compound interest works when you have a mortgage:

Compound interest involves adding interest to the principal sum (the amount you’ve borrowed) of your loan, and then deducting your repayment. 

Then you’re charged interest on your remaining debt again, and this is added on again – cycling the loan amount upward, as your repayments are applied. 

This is why the first few years of your home loan feel so tough – like running on ice and getting nowhere fast. But over time the principal amount owing reduces, and more and more of your repayments start to make a dent in the overall amount of money you owe on your home.

Strategies to minimise compound interest on your home loan:

Paying off your principal loan as quickly as possible is probably the most effective strategy to becoming mortgage free. 

Let’s consider an example similar to the one mentioned in the viral TikTok video: 

Say you have a $500,000 mortgage with a 5 per cent interest rate and a 20-year loan term:

  • If you make monthly repayments of approximately $3300 (or $39,600 per year), it will take you the full 20 years to repay your loan. 
  • Over this period, you’ll pay approximately $792,000 in total, with around $291,950 being interest.

By paying $1650 every fortnight (half of your monthly repayment), you will pay $42,900 per year instead of $39,600.

This allows you to repay your loan in just 17 years and six months, saving you approximately $41,750 in interest – and releasing you from debt two years and six months earlier.

Can paying $1 extra per day into your mortgage make a difference?

The world according to TikTok is a weird and wonderful place, but it’s no substitute for qualified financial advice.

On our $500,000 mortgage above, paying an extra $1 a day will only reduce your repayment period to 19 years and nine months, saving you about $5470 in interest. This isn’t bad of course, but it’s not a big difference, and it’s a far cry from the claim that adding $1/day can cut your loan length from 20 years to just five.

There is no magic trick to ‘beating’ compound interest. Making your repayments more frequently, such as daily or weekly, won’t make a significant difference to your home loan unless you increase the amount you pay, as in the fortnightly repayment example above.

Making higher repayments reduces the amount you owe faster, and the interest component of your repayment will be less. 

This means more of your repayment is applied to your principal loan amount and your debt reduces more quickly – which is an example of compound interest working in your favour, instead of your lender’s.

Want to pay off your mortgage quicker? My colleague Sophie Matthews has a few strategies, such as getting an offset account. It’s well worth a read.

The bottom line

There are no secret hacks to avoid compound interest. 

  • You can choose to refinance to a lower interest rate, and maintain your repayments at their old level, which will see you paying off your home loan sooner. 
  • The most effective way to minimise compound interest on your mortgage is to pay off your home loan as quickly as possible. 
  • Make sure you’re aware of any penalties or fees associated with making extra payments on your home loan.

How have you used compound interest to your advantage? Did you make larger home repayments and pay off your mortgage quicker? Let us know in the comments section below.

Also read: Why you need to know your risk profile

Disclaimer: All content on YourLifeChoices website is of a general nature and has been prepared without taking into account your objectives, financial situation or needs. It has been prepared with due care but no guarantees are provided for the ongoing accuracy or relevance. Before making a decision based on this information, you should consider its appropriateness in regard to your own circumstances. You should seek professional advice from a financial planner, lawyer or tax agent in relation to any aspects that affect your financial and legal circumstances.

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