Compound interest can work for us. But it can also increase the cost of our debt. Either way, over the long run, we’re talking serious dosh!
The best compounding happens when any interest we earn gets reinvested and earns even more interest.
It’s interest earning interest, and our money is working for us instead of us working for it!
The longer we leave our money, the more powerful the compounding interest effect. So the earlier we start saving, the more we make from compound interest (of course, only if we don’t withdraw the interest).
The same applies to other investments such as shares, where we regularly reinvest dividends, or when the company reinvests its profits.
Compound interest also applies to debt – although not in a good way. Costs can compound too. The slower we repay a debt which charges interest, the more we end up paying back over time.
So the choice is to have compounding interest work for us or against us, and unfortunately the effects can be devastating if we’re always on the wrong side of things.
If you're dealing with debt, take a look at the managing debt guide.
The table below shows the power of compound interest working for us. The results are based on an interest rate of 2.5% after tax and allowing for inflation.
It also assumes that we’ll increase the amount we save each week to account for inflation. So if inflation is 2% this year, we’d increase our weekly savings by 2% from next year (from $50 to $51).
Look at the first five years and the last five years of the table. In the first five years we save $2,600 and earn $170 in interest. In the last five years, we’re still saving only $2,600, but earn a massive $3,970 in interest – far more than we save. That's the power of compounding interest!
If we start saving $10 a week when we’re 20, by the time we’re the age in the left hand column we’ll have saved the amount in the right hand column.
Age |
Savings |
Interest |
Total |
|
25 |
$2,600 |
$170 |
$2,770 |
|
30 |
$5,200 |
$700 |
$5,900 |
|
35 |
$7,800 |
$1,640 |
$9,440 |
|
40 |
$10,400 |
$3,050 |
$13,450 |
|
45 |
$13,000 |
$4,980 |
$17,980 |
|
50 |
$15,600 |
$7,510 |
$23,110 |
|
55 |
$18,200 |
$10,710 |
$28,910 |
|
60 |
$20,800 |
$14,680 |
$35,480 |
There’s an easy rule we can use to work out how our savings or investments can grow with compounding interest.
The result shows how long it will take for our money to double without further savings.
For example, take $10,000 that is earning 6% interest (after tax). 72 divided by 6 = 12.
Every 12 years that $10,000 will double, so:
To be completely accurate, we would need to reduce the interest rate to allow for inflation. For example, if we allowed for 2% inflation, the real interest rate would be 4%.
Sound complicated? This savings calculator does all the maths for us.
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