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What is compound interest, and how does it help me?
Compound interest is a way to earn interest on interest. This means that if you invest your money in a product where your interest is calculated on the total of the amount you invested plus the interest that it has earned, you’re getting the benefit of compound interest.
Compound interest is different from simple interest, which is calculated only on the money that you deposit. Most savings accounts offer compound interest, so you earn interest on
- The money you deposit in the account, and
- The interest that your money has earned.
If you were to deposit $1,000 for three years in an account that gave you simple interest of 3.5 per cent, the interest you’d earn would be 1000 X 3.5/100 X 3, which equals $105.
But if you deposited the same amount for the same duration in an account that gave compound interest calculated on a daily basis, the interest you earn would be $107.
While this may appear to be a small difference in this example, it becomes substantial over time. Compound interest offers a way for you to build your wealth by growing your savings exponentially.
To maximise your gain from compound interest, keep depositing whatever you can spare into your savings account. If you can limit your withdrawals and keep your savings over a long time, compound interest can help to build your wealth substantially.
The formula to calculate compound interest is
A= P X (1+r/n) ^ nt
Where
- P is the principal that you deposited into the savings
- r is the interest rate per year divided by 100 (for example, 3% becomes 0.03)
- n is the number of years for which you keep the money in the account, and
- A is the amount you get
- t is the number of times the year occurs
You can easily find an online calculator and get the compound interest calculated by just entering the details.
Please note that interest on savings accounts are compounded daily but added monthly. The compound interest formula above does not perfectly apply for all Australian savings accounts. For majority savings accounts, interest is compounded daily but added to your balance at the end of each month. This is a general example, to illustrate how compound interest can be calculated.
The more frequently your interest is calculated, the faster your savings will grow. So, daily compound interest may be preferable compared to monthly, quarterly or annual. Again, as your interest may be calculated daily, it would generally be credited to your account only at the end of each month.
When you’re choosing a bank and account type for saving, remember to compare the interest rates and how frequently the interest is compounded. Also, check on other conditions, such as whether you need to maintain a minimum balance. The interest you earn usually does not count towards the minimum balance, so you need to maintain that amount as a deposit.
Savings interest rate calculator: How much interest can you earn?
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