How compound interest works.

Money matters
6 March 2019 |  6 min read 

 

Compound interest is one of the most powerful forces in finance, yet it is not widely understood or harnessed. Here’s how it works.

What is compound interest

In simple terms, compound interest means earning interest on your interest on your interest, and so on.

The Australian Securities and Investment’s Commission’s (ASIC) Moneysmart.gov.au service describes it as like “double chocolate topping for your savings”.

“Compound interest is interest paid on the initial principal as well as the accumulated interest on money you have borrowed or invested,” it says.¹ “You earn interest on the money you deposit, and on the interest you have already earned.”

What compound interest means for savings

Superannuation is perfectly placed to benefit from compound interest because many people’s money is invested in super for decades, so the compounding effect happens automatically.

ASIC’s Moneysmart compound interest calculator is a good way to try some scenarios and see where compound interest might take you.

For example:¹

	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, according to ASIC’s calculator.
$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	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.

Compounding and debt

Compounding may work in reverse for people with debt.

Mortgage debt is the biggest loan that many people have in their lifetime, and the interest paid can be significantly reduced if borrowers make extra payments and let them compound.

ASIC’s Moneysmart mortgage calculator can help with the number crunching here.

For example:

A simple $400,000 mortgage at 5% over 30 years will cost around $2,147 a month to repay. However, if a borrower is able to pay an extra $100 a month off the loan principal they could save more than $41,500 in total interest costs and wipe three years off the life off the loan.

Why advice is important

Harnessing the power of compound interest may be a priority for super fund members, investors, savers and borrowers.

As with all money matters, it may be worth seeking budgeting and investment advice around compound interest to make sure this wonder of the financial world works best for you.

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The views of the author are not necessarily the views of the QSuper Board. Visit qsuper.qld.gov.au for more information

1. Moneysmart.gov.au guide to compound interest, accessed January 2019 www.moneysmart.gov.au/managing-your-money/saving/compound-interest
2. ASIC’s Moneysmart superannuation calculator, accessed 1 March 2019. 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.
3. This is a model, not a prediction. Amounts and repayment periods are estimates only, actual amounts may be higher or lower. No account fees are taken into account. It assumes that interest rates do not change for the life of the loan. Interest is calculated by compounding on the same frequency as the repayment selected, i.e. weekly, fortnightly, monthly quarterly or annually. It does not take into account up-front fees such as loan establishment fees.