The magic of compound interest

Interest is calculated on the increasing balance, generating more and more interest.

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.

Happy cyclist
4th Aug 2015
10:20am
I'd like to know where Jack put that \$10,000 at 5 per cent. That sort of interest just seems like 'the good old days' now!
Anonymous
4th Aug 2015
11:47am
At this moment the BEST interest you can get on a term deposit is 3.6% for SIXTY MONTHS with some online ADI's, 2.6% is more like it with superannuation term deposits for three to twelve months. The Centrelink deeming rate certainly needs readjustment.
MICK
4th Aug 2015
12:09pm
4% still available from bank interest. At Call account.
4th Aug 2015
10:30am
Yes, 3.4% is the best I can find ( no fees). With all the changes govt are proposing, I am loathe to put it in annuities as my kids will get nothing if I die before using it all!
PlanB
4th Aug 2015
10:53am
Yes 5% is ancient times
Jude
4th Aug 2015
11:06am
Recommend everyone read Super Reality Check discussion paper http://www.aist.asn.au/media/15000/2015_Retirement_Incomes_Paper_FINAL_FOR_RELEASE for he facts on super and retirement income.
Sets out the facts on Super and the Age pension, worth reading.
PlanB
4th Aug 2015
11:13am
I never had any super when I was working
Anonymous
4th Aug 2015
12:08pm
If you are willing to trust a bank with your money why not buy their shares and achieve a much better return tax free ...You pay tax on your fixed deposit . But not on dividends so you can double your return ..
MICK
4th Aug 2015
12:14pm
And if you do not have an income which is under the tax free threshhold (thanks previous government!) then you get the tax that banks pay back as well. Call imputed dividends. A good deal.
But remember that banks may not always do as well as they have. The government is requiring banks to hold more cash (so that a run of withdrawals, should it happen. will not result in banks closing their doors like they did in Greece recently) and of course if the global downturn persists then the only real export industry we have (ore) will tank further and we will all suffer. The results of successive governments which have closed down manufacturing with their economist rhetoric and BS.
Anonymous
4th Aug 2015
1:57pm
You are incorrect that the only export industry we have is ore. Gas is bigger and service industries earn more foreign dollars than Agriculture and mining combined.
Our banks are as safe as houses due to the govt silly four banks policy ..
Manufacturing has never been a big export dollar and subsides manufacturing for the home market has cost us dearly..,
PlanB
4th Aug 2015
3:50pm
Rob
4th Aug 2015
6:50pm
The trouble is PlanB we, as consumers, don't want too buy what we make in Australia. The car industry a good case in question. People are preferring the VW's, Subaru's etc.
MICK
4th Aug 2015
8:55pm
Australia does have a lot of LNG but WE DO NOT OWN IT as the assets were flogged off to overseas companies. Australia now gets a miserly royalty.
Meanwhile Australians have a gas shortage in a country overflowing with the stuff. Thank you John Howard.
You miss the point about manufacturing. Everything we make make here is money saved because that item does not need to be imported. Your last comment Pete ignores the fact that when a few dollars are spent with a subsidy this is a great outcome when an industry employs hundreds of thousands of Australians (directly of indirectly) as the car industry does.
Bazbee
6th Aug 2015
4:06pm
Recent reports have pointed out that the much-vaunted 'you will need at least a million in super to live comfortably in retirement' that the media has promoted over the last 20 years is a furphy, probably driven by the super and investment industry. This might be applicable to workers today who are due to retire in 30+ years but the age pension should be included in the equation for today's retirees who can live quite comfortably if they are lucky enough to have accumulated a few hundred thousand in super + the age pension. You shouldn't need a million in super unless you are addicted to going on overseas trips every 6 months.
Rae
10th Aug 2015
9:11am
Doing the maths using compounding certainly should work.

However in real life the superannuation funds just aren't that good.

I paid in after tax dollars and over 43 years the fund only managed to double the amount I paid.
That same spend invested in real estate would have bought 8 properties and a fraction invested in Commonwealth bank shares and left to compound would be worth millions.

As far as I can see Superannuation is designed to ensure your working income is ordinary and then your retirement income is even worse.

Those doing well out of superannuation include the fund CEos and board, the traders, the banks and insurance companies but the superannuant certainly isn't.