“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays for it” – Albert Einstein
One of the lesser known quotes from Albert Einstein, but certainly one of the most important.
Conceptually, compound interest is the interest on the principal amount (i.e. amount invested or deposited into your bank account), plus interest that has already been earned.
The formula for compound interest is below. Alternatively, you can use an online calculate like on the MoneySmart website: https://moneysmart.gov.au/budgeting/compound-interest-calculator
A = P x (1 + r)n
- Where:
- A = final amount, including principal
- P = principal amount
- r = interest rate per period (e.g. per year)
- n = number of periods (e.g. years)
Compound interest is different to simple interest, which calculates interest earned based on the principle value. An example of a financial instrument utilising simple interest is a bank term deposit – you invest $5,000 into a term deposit, earning 2% p.a. If the agreed term is 1 year, then at the end of the period you receive you $5,000 back plus 2% interest ($100 in this case). If the agreed term is 2 years, then you receive $5,000 back plus 2% interest for each year, based on the principal amount ($100 for each year, so you receive $200 at the end of the 2nd year)
The graph below clearly shows the power of compounding – earning interest on interest. Compare this value to the linear line which depicts the same principal value earning simple interest.
Compound interest is a double-edged sword – it is your best friend when it works in your favour, but your worst enemy when it works against you.
How does it work for you?
Through saving and investing. By doing this, we are earning interest upon interest, letting compound interest do its thing. Of course, investing carries risk of potential losses so returns are by no means guaranteed. Providing regular contributions over time will amplify the compounding effect.
How does it work against you?
It works against you through paying back debt – for example racking up credit card debit, you’re being charged interest on your interest. The interest rate on most credit cards are astounding – they are easily in the double digits! This means that the longer it takes to pay off a debt (the debt is accruing interest whilst you pay it off), the more it is going to cost you. Another example is a home loan, also known as a mortgage. Over the course of 30 years, we will be paying back a bit of the loan, but also the interest on the principal remaining. Although we are given a loan for say, $300,000 at an interest rate of 2% for 30 years, by the time we have paid off the loan we may have paid a total of close to $400,00000 – $100,000 in interest, $300,000 paying off the principal of the loan. This scenario is a little bit different to credit card debt, as most people probably don’t have the cash up front to purchase a house.
If you made it this far, then well done. Hopefully you learned a thing or two about the power of compound interest, and use your understanding to make it work for you!