How compound interest works
29 January 2020
5
min read
Compound interest is one of the most powerful forces in finance.
Albert Einstein is said to have famously described compound interest as the eighth wonder of the world.
The Australian Securities and Investment’s Commission’s (ASIC) MoneySmart website1 describes it as “double chocolate topping for your savings”.
Compounding is the process of earning interest on interest.
Compound interest is interest paid on the initial principal as well as the accumulated interest on money you have borrowed or invested,” MoneySmart says. “You earn interest on the money you deposit, and on the interest you have already earned.”
Compound interest in practice
ASIC’s MoneySmart compound interest calculator2 illustrates where compound interest might take you and the impact of starting early for long-term investing.
The calculator shows that through investing early and utilising compound interest, a 20-year-old who starts putting aside $190 a month at an 8% investment return may be a millionaire by the time they’re 65 years old.
With $102,600 in regular deposits over 45 years, they may earn $899,563 in total interest for total savings of $1,002,163.
What compound interest means for savings
Superannuation is perfectly placed to benefit from compound interest because the compounding effect happens automatically over decades.
According to the MoneySmart compound interest calculator3:
 |
A 25-year-old who earns $50,000 a year and wants to retire at 60 could have a super lump sum of $344,000 (not including insurance costs and inflation) if they invest in a typical growth fund for those 35 years. |
 $10,000 |
If that same person started with $10,000 in super at age 25 their final balance could be almost $380,000 – so that $10,000 at the start creates an extra $36,000 of wealth through compound interest. |
| $25/week
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And if they also decided to deposit $25 a week extra into their super through salary sacrifice, their final super balance could be $458,000. At $50 extra per week the super end balance becomes $537,000, thanks in part to the benefit of compounding returns. |
1. Australian Securities and Investment Commission, MoneySmart, Guide to compound interest, accessed 4 December 2019 at https://www.moneysmart.gov.au/managing-your-money/saving/compound-interest
2. ASIC, MoneySmart, Compound Interest Calculator, accessed 5 December 2019, at https://www.moneysmart.gov.au/tools-and-resources/calculators-and-apps/compound-interest-calculator
3. The calculator works for accumulation funds only. It will not work for defined benefit funds. We assume your account balance will receive all income and outgoings mid-year, apart from Government co-contributions which we assume are received at the end of the year. We assume that your employer contributes an amount equal to 9.5% of your ordinary time earnings. We make the following assumptions about investment options and returns: invested in a Growth fund with assumed investment return (before tax and fees) of 5%, investment fees of 0.6% and assumed tax on investment earnings of 5.8%. ASIC advises that these assumed default investment returns and tax rates are based on actuarial advice received in June 2018. Actual returns will vary significantly from year to year and could be negative in some years, particularly for investment mixes where more is invested in shares and property. This calculator does not allow for such variations. Amounts have been rounded.