The Joy of Compound Interest

How can you make your savings work even harder for you? Make money on the interest as well as the lump sum. It’s called compound interest. Here’s what you need to know.

There are any number of compound interest calculators available on the Web but the principal of compound interest is really very simple: it’s money you make on your savings, that you then make more money on; interest on your interest.

This is why saving even a little bit of money at regular intervals can make such a big difference to most people.

The savings habit

The concept of compound interest can get a bit theoretical so we’ll use an example to explain. Take the story of 23-year-old Robert. He’d finished uni and had just started in his second full-time job but had never been a very good saver, always spending money as it came in, living week to week. Not surprisingly he didn’t have much to show for himself. His friends were starting to plan overseas holidays but he couldn’t seem to save even a cent. Distressed, he spoke to his dad, who told him to put aside $25 a week no matter what and showed him why. Using a compound interest calculator his dad found on the Net together they calculated how much money Robert would have in only five years if he saved just $25 per week.

Without taking interest into account, Robert would end up with $6,500. That’s $1300 a year over five years. If he placed the money into an account that earned seven percent interest, he would make seven percent on $6500, which is $455. In five years time he would have not $6500 in the bank but $6955 (his savings plus interest). However – and here’s the good bit – if he left that money and interest in the account with compounding interest in five years time his $6500 in contributions would be worth $8000. That’s an extra $1045 in interest on his interest, or the equivalent of a whole year of savings. If he kept saving that way in 20 years time he would have more than $57,000. If he kept it up for 30 years he'd have $131,395 (more than double his money in half the time).

Interest calculated daily

The key is to reinvest your earnings, leaving your interest in place to help make you more money. If the interest is calculated daily, that’s even better. If it’s paid weekly or monthly then you are also better off. If you choose an account that only pays interest once a year, then your ability to earn compound interest is reduced. It’s generally better to earn interest on smaller amounts more often than a lump sum interest payment once a year.

Start saving sooner not later

If you are new to saving you probably don’t know how much you are spending right now. Before you make a savings plan working out what you spend your money on is a good idea. Keep a little expenses diary for a week or even a month and write every little thing down. The key to successful saving is to set attainable goals. If you make it too hard for yourself you won’t be able to get into a consistent habit and may end up throwing the whole idea away. Set yourself up for success so that saving can become second nature.

Saving 10 percent

If you have an irregular income, setting yourself a goal to save 10 percent of whatever you earn may be a better way to organise yourself. For people with a fixed income, consider setting up an automated deduction from your bank account into a high interest savings account each week.

Here are some other scenarios to consider:

If Mary started saving $40 from the age of 35, at seven percent interest by age 65 she would have $66,768. With compound interest, however, she would have $210,232.

If Abbey began saving when she left home at 18, putting just $20 away each week and earning seven percent on her savings, by the time she was 65, with compound interest, she would have $366,361 in her bank account.

Twenty dollars today can be worth a whole lot more in future. Considering most people have $20 they won’t miss too much, it makes sense to start tucking it away and getting it working for you.