As always, the content below is meant as general information to give you a better understanding of this topic, and is subject to our terms and conditions. You should seek appropriate personalised financial advice from a qualified professional to suit your individual circumstances.
So, compound Interest. Never heard of it? Fair enough. The purpose of this blog is to:
Explain what compound interest is
Help you understand why it is so valuable, so that hopefully you can take advantage of its key benefits, and make it a part of your long-term financial future
First, let’s cover off “interest” - this is the ‘fee’ you either pay (when you borrow money) or receive (when you loan money). It’s almost always calculated as a % of the amount borrowed, per year. So if you borrowed $100,000 at a rate of 4% - you would pay $4,000 of interest per year.
Many people don’t realise that when leaving money in their bank account, they are effectively ‘loaning’ that money to the bank. In return, they receive interest. Sometimes it’s not that much, which is why it pays to check the level of interest paid on your savings and everyday accounts.
There are other ways to earn interest, for example term deposits.
Compound interest is pretty simple. Each time you are paid interest, just leave it in the account. Don’t withdraw it, don’t spend it, just leave it. Then, the next time you are paid interest, you’ll be earning interest on your interest.
Albert Einstein called compound interest “the eighth wonder of the world.” - Okay, so that’s quite extreme, but it is pretty amazing.
Let’s say you have $1,000 in the bank earning 4% interest per year. By the end of the year, you will have received $40 of interest, and will then have $1,040 sitting in your account. The following year (as long as you haven’t withdrawn the money), the 4% of interest will be calculated on the new amount (the $1,040) - not the $1,000.
So, at the end of year 2, you will have $1,081.60 in the account - you received $41.60 of interest, instead of the $40. You earned interest on your interest.
This might not sound like much. It’s not even enough for a flat white. But let’s fast forward 10, 20, 30 and even 40 years. Compound interest shines the longer you leave it.
Example 1: Compound interest (4% per year) with a $1,000 initial deposit and no regular deposits.
Example 2: Compound interest (4% per year) with $1,000 initial deposit and $20 regular deposits each week.
How to make the most of compound interest
1. Start early, save regularly – Save small amounts often. As shown above, saving as little as $20 a week can create a very nice nest egg thanks to compounding interest. A lot of the time, saving small amounts earlier in life will have a greater impact than saving larger amounts later on.
2. Check the interest rates on your bank accounts – A survey* shows that around 62% of Kiwis use their savings account as their primary investment strategy. That’s okay, but it means we should be paying extra attention to the details - e.g. the interest rate and how often it’s compounding (generally speaking, the more frequent compounding, the better).
A cheque or ‘everyday’ account linked to your Eftpos card typically earns no interest. If you’re keen to start saving, have a look at your bank's website to see what kinds of savings accounts are available, and at what interest rate. You can check out what you bank is offering and compare to others in the market here: https://www.interest.co.nz/saving/call-account
3. Get excited about the numbers!
So maybe numbers aren’t the most exciting thing. But the rule of 72 is an easy tool you can use to figure out how your savings or investments can grow with compound interest. Simply divide the number 72 by the interest rate. The answer shows how many years it will take for your money to double.
o E.g. if you have $5,000 earning 4% (after tax). 72 divided by 4 = 18 years.
o Every 18 years, your money will double.
There’s a handy tool you can use to see what your money may look like in the years to come: Compound Interest Calculator
Compound interest on our debt
Unfortunately, compounding interest can work against us as well, making it more difficult to pay off debt. The longer it takes us to repay debt that charges interest, the more we ultimately end up paying.
If you do have debt such as credit cards or pay day loans, compound interest can work against you. To work out how much you will pay over the lifetime of the loan, check out this debt calculator.
So, there you have it. A bit of an explanation about compound interest and you can use it in your long-term financial planning.
If you have any questions, please get in touch with us - We would love to hear from you.