Our money expert Craig Hall explains compound interest, revealing the long-term effect and benefit of saving early.
Calculating interest using the compound method is widely used in the financial services industry for both credit and investment products but for many consumers it is not easily understood.
Basically, with compound interest, interest is calculated on the principle as well as the interest that has already been credited to the account – hence the saying ‘you earn interest on your interest’.
The effects of compound interest can vary according to the frequency of the interest payments and how often interest is calculated. Simple interest, on the other hand, only calculates interest on the principle, which, therefore, keeps the return constant.
Let’s take an in-depth look at how compound interest works. When you invest in a product that uses the compound-interest method, interest is calculated on the balance at the rate offered by the financial institution; this commonly occurs daily. These interest amounts are then totalled and added to the principle amount at certain frequencies, which could be monthly, quarterly, yearly and/or at maturity, depending on the product. After the interest is added to the principle, this total amount, consisting of the principle and interest, is then used to calculate interest for the next period.
For example, on 1 July, Jack invests $10,000 into an account that pays five per cent per annum, calculates the interest daily and credits interest monthly. Each day in the first month, the principle amount of $10,000 is multiplied by five per cent and divided by 365 (365 being the number of days in the applicable year) to determine the daily interest – in this case approximately $1.37 per day. These daily amounts are then totalled and added to the principle amount at the end of the month resulting in a higher balance of approximately $10,042.47.
In the second month, the updated balance is used to calculate the interest each day until the end of the following month, when the second payment (approximately $42.65) is added to the principle, bringing the balance to $10,085.12.
As time goes on, the interest is calculated on the increasing balance, which, therefore, generates more and more interest. While this example shows the small increase in interest, the benefits are really gained over the long term.
So let’s look at Jack’s scenario over five, 10 and 15 years, when the results of earning an increased amount of interest are more obvious. Again, assuming that the interest rate remained at five per cent, it is projected that Jack’s balance will be approximately $12,834.00 after five years, $16,470.00 after 10 years and $21,137.00 after 15 years.
This shows that in the first five years, the interest calculated is approximately $2,834; from year six to 10, it increases to $3,636; and in the last five years, it increases again to approximately $4,667. Projecting this scenario out even further would make Jack’s total balance $27,126 after 20 years, $44,670 after 30 years and $73,584 after 40 years.
As you can see, the effect of compounding over time can be significant, but what if Jack could make regular deposits as well? As you would expect, this would increase the effects of compounding further, as every time Jack deposits money, the interest is calculated on a higher balance, which increases the end result.
However, the timing of the extra deposits can also influence the result. For example, if Jack invests his $10,000 for a term of 20 years at five per cent and contributes an extra $100 per month in the final 10 years (an additional $12,000), he would end up with approximately $42,654.00. But if Jack spread the extra $12,000 in contributions over the whole 20-year term at $50 per month, his balance after 20 years would be approximately $47,678. However, if he made those extra contributions in the first 10 years of the term at $100 per month, he would have $52,701 at the end of the 20-year term.
This example shows that contributing extra funds at the beginning of the investment term is more beneficial. The same principle applies to repaying loans that are calculated the same way. Generally, the more that you repay at the beginning of the loan, the less interest you’ll be charged and your loan will reduce more quickly.
So when considering cash-based investment products, look not only at the rate offered, but also how the interest is calculated and the frequency at which it is credited. Use savings and investment calculators to project the results, as they can vary between products. In some cases, a product that pays a slightly lower interest rate but credits the interest more frequently can result in a higher balance.
Please note that the information in this article does not constitute or imply financial advice. It is recommended that you seek professional financial advice and/or seek clarification from any relevant government department or financial services provider before making financial decisions.
Savings and investment calculators are available on most financial institution websites, as well as on the Government’s MoneySmart website.