The power of compound interest

10 Mar 2021

How do you react when you hear the words “COMPOUND INTEREST?”

Do you break out in a cold sweat and get flashbacks from your high school maths class? Or do your eyes glaze over completely? Well, you should be thinking and feeling the exact opposite: When it comes to your financial future, compound interest is your best friend.

What is interest?

Interest is the money that a bank or a fund (like Commonwealth Superannuation Corporation) pays you for entrusting them with your money. The interest you’re paid is based on the amount of money you give them. The more money you entrust, the more money you receive as interest.

What is compound interest?

Compounding means it grows on itself. As time goes on the amount snowballs, continually getting bigger and bigger. Basically, it’s earning interest on interest; money on money. The more money you have, the more that growth will accelerate over time. Suddenly, those maths classes don’t seem so boring!

How does it work?

The magic of compound interest is that you double dip - you make money on your initial deposit and again on any interest you’ve earned.

Here’s how it works:

If Sarah had an initial deposit of $1000 and it compounded at 5%, after one year Sarah would make $50 for doing nothing. Sarah’s total would be $1050.

If Sarah waited another year, that would jump to $1102.5.

This might seem a little underwhelming, but here’s what happens to that money when Sarah leaves it compounding for years, or even decades:

Year 5: $1,276.28

Year 10:
$1,628.89

Year 25:
$3,386.35

Year 50:
$11,467.40

For doing absolutely nothing, Sarah’s initial $1000 (that’s called the “principal”) has increased in value by 1047% over 50 years.

Be patient, and watch the money roll in

This isn’t a get rich quick scheme. Once you master it, compound interest can be a life-changer. Each pay cycle, your employer already takes money out of your pay and puts it in your nominated superannuation fund. However, if you were to add a few dollars more on a regular basis, the results are seriously impressive.

Here’s what it would look like if Sarah was to deposit just $25 a week into an account that compounds at 5% a year:

Year Balance
1 $1,331.61
10 $16,748.86
25 $63,553.92
50 $278,770.06

There’s your compounding interest magic: sacrificing $25 a week over 50 years can earn Sarah over a quarter of a million dollars.

Start young!

The earlier you start saving, the better; when adding savings to time, you have serious money-making potential.

Let’s have a look at how starting your savings journey early can earn you huge benefits later in life.

Both Sarah and Jess are investing the same amount of money per month ($250) for exactly 10 years compounding at 5%. Sarah saves from the ages of 25-35, while Jess saves from the ages of 35-45.

Here’s how their investments look once they hit the retirement age of 65:

Sarah: $166,787.17

Jess: $102,392.86

The extra 10 years of compounding has given Sarah an extra $64,394.32!

Compound calculators

Compound interest calculators are a great resource to play around with. If you’ve accumulated some super already, you can get an idea of what your financial future could look like, and it looks way more impressive when you add a few more dollars to your compulsory contributions.

The power of compound interest

Hopefully this has dispelled some of the confusion you may have had surrounding compound interest.

While it may at first seem like a daunting concept, it’s a magic trick for your finances if it’s understood and utilised early.

'Be patient' assumption:
  • initial deposit of $0
  • $25 starts one week later
  • 5% p.a. effective rate
'Start Young' Assumption:
  • Initial deposit of $0
  • $250 starts one month later
  • 5% p.a. effective rate

Is important that you know, this information is not financial advice, and doesn't take your personal circumstances into account. The information above is a guide to how CSC calculates compound interest, and other general information about compound interest.

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