Understanding how compound interest works can help you choose an investment or savings account where your money works harder for you. By earning compound interest, you can grow your personal wealth faster.
Compound interest is where you earn interest on your principal investment (or deposit), and then you earn interest on your interest as well. An online savings account paying monthly interest is a good example of an account earning compound interest.
How Does Compound Interest Work?
When you’re saving, the bank or financial institution you’re with adds interest to your savings at regular intervals. If you leave the interest untouched and let it add to a lump sum, you begin earning interest on that interest on top of the original amount you saved.
The longer you leave your money, the greater the effect of compound interest. This means that the earlier you begin saving, the more wealth you can build using compound interest.
This same principal applies to investments like shares, where you reinvest dividends or the company reinvests profits.
Examples of the Compounding Effect
Let’s say you invested $10,000 for five years with an interest rate of five per cent per year.
Paid at the end of the term, you would end up earning $2,500 in simple interest ($500 per year). This would give you a total of $12,500 at the end of the term.
If interest was calculated and added monthly in this scenario, you could earn $2,834 in compound interest over five years as you would be earning interest on the interest. This would give you a total of $12,834 at the end of the term. You will earn more money if you’re paid compound interest as it grows every year, unlike simple interest which accrues at the same rate.
Formula for Compound Interest
You can do your own compound interest calculation using this formula:
A = P x (1 + r) n
A = end amount of your investment
P = principal investment
r = percentage interest rate converted to decimal (e.g. 5 per cent is 0.05)
n = number of time periods interest is compounded
So to figure out what $2,000 will grow to over two years at 5 per cent per year compounded yearly:
A = $2,000 x (1.05) 2
A = $2,205
If interest was compounded monthly, n would be 24, representing the number of months in the two-year period.
The Rule of 72
Another way of understanding the power of compound interest is the rule of 72. This involves dividing the interest rate or average annual return into 72, which tells you how long it will take for your money to double.
So for $10,000 earning five per cent interest, you would divide 72 by 5 which equals 14.4.
This means you can double your $10,000 roughly every 14-and- a-half years. After 43 years,
that adds up to $80,000. You can see how handy compound interest can be for a savings strategy or for retirement plans.
Keep in mind that to be more accurate, you would have to deduct from the interest rate to allow for inflation, e.g. 2 per cent inflation means the real interest rate would be 3 per cent.
For more information about how you can use compound interest to build wealth in your specific situation, speak with a financial specialist. Remember that not all financial institutions treat cash investments the same way. Some compound interest daily for savings accounts, while others do it monthly, quarterly or even annually. Some charge fees while others don’t.
If you’d like practical and tailored advice about compound interest from an independent financial services professional, get in touch with Wealth Health. We’re based in Papamoa and can visit clients in Tauranga, Waikato, Mt. Maunganui and the wider Bay of Plenty.
We help our clients obtain great mortgage deals, insurances, plus we offer specialist financial and investment advice. For all inquiries, call Craig on 027 667 2537 or contact WealthHealth online. Check out our blog section for great tips and articles.