Compound interest

Increase your savings

Understanding how compound interest works can help you choose a savings accounts or investment where your money works harder for you. If your money is earning compound interest, your savings will grow faster.

What is compound interest?

Compound interest is interest paid on the initial principal as well as the accumulated interest on money you have borrowed or invested. Compound interest is like double chocolate topping for your savings. You earn interest on the money you deposit, and on the interest you have already earned - so you earn interest on interest. An online savings account paying monthly interest is an example of an account that earns compound interest.

Compound interest is different from simple interest. With simple interest, interest is paid at the end of a specified term, although if the term is more than 12 months, interest may be paid annually. A term deposit is an example of an account that earns simple interest.

The compounding effect

If you invested $10,000 for 5 years at 5% per year, with interest paid at the end of the term, you would earn $2,500 in simple interest after 5 years, $500 for each year. This would give you a total of $12,500 after 5 years.

If you invested $10,000 for 5 years at 5%, with interest calculated and added monthly, you would earn $2,834 in compound interest after 5 years, giving you a total of $12,834. Returns would be higher because you'd earn interest on the interest.

Here's how we calculated the figures in the example above.

Simple interest on a $10,000 investment at 5% per year, paid at the end of the term

  Year 1 Year 2 Year 3 Year 4 Year 5
Deposit $10,000 $0 $0 $0 $0
Interest $0 $0 $0 $0 $2,500
Total $10,000 $10,000 $10,000 $10,000 $12,500

Compound interest on a $10,000 investment at 5% per year, paid monthly

  Year 1 Year 2 Year 3 Year 4 Year 5
Deposit $10,000 $0 $0 $0 $0
Interest $512 $538 $565 $594 $625
Total $10,512 $11,049 $11,615 $12,209 $12,834

Comparing compound and simple interest earnings on $10,000 at 5% per year 

compound interest example

You can see how simple interest accrues at the same rate each year while compound interest grows every year. You will earn more money if you are paid compound interest.

Use our compound interest calculator to find out how much you can interest you can earn on your savings.

Compound interest formula

If you're interested in doing your own compound interest calculation, here's how.

Use the formula A = P x (1 + r)n

Formula explanation
'A' is the end amount of your investment
'P' is the principal, i.e. the starting amount
'r' is the percentage interest rate converted to a decimal rate (e.g. 2% is 0.02)
'n' is the number of time periods

Example 1 - annual compounding

Work out what $2,000 will grow to over 2 years for an investment or savings that grow at 5% per annum compounding yearly.

A = $2,000 x (1.05)2

A = $2,000 x 1.1025

A = $2,205.00

Example 2 - monthly compounding

Work out what $2,000 will grow to over 2 years for an investment or savings that grow at 5% per annum compounding monthly.

First you need to divide the annual interest rate by 12, which is 0.42%. You also need to calculate the number of time periods ('n') in months, which is 24.

A = $2,000 x (1.0042)24

A = $2,000 x 1.11

A = $2,211.64

Effective interest rates

Not all financial institutions treat cash investments the same way. Some compound interest monthly, others quarterly or even annually. Some charge fees, others don't.

An effective interest rate, also known as an effective yield or the annual percentage rate (APR), takes all of this into account and expresses the rate in simple interest terms.

Your balance at the end of a year is compared to your balance at the beginning of the year and any increase is expressed as a percentage of the opening balance. The effective interest rate is the interest rate you would have been given, to achieve the same closing balance, if you did not have the benefit of compounding interest or been charged any fees.

Knowing the effective investment rate for an investment allows you to compare it with accounts or investments offered by different financial institutions.

The cost of delaying saving

If you're thinking of delaying your saving and making up for the delay by saving a higher amount in the future, read the case study below.

Case study: Nicky and Adam compare their savings

Nicky saves $50 per week for 10 years and puts her money into a high interest savings account at 5% interest, compounding monthly. The figures below show that she ends up with $33,644 after 10 years.

  Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total
Deposits $2,600 $2,600 $2,600 $2,600 $2,600 $2,600 $2,600 $2,600 $2,600 $2,600 $26,000
Interest $60 $197 $340 $490 $648 $814 $989 $1,172 $1,366 $1,568 $7,644
Yearly Total $2,660 $2,797 $2,940 $3,090 $3,248 $3,414 $3,589 $3,772 $3,966 $4,168 $33,644

Adam puts off his savings for 5 years but then saves double the amount that Nicky does, $100 a week into a high interest savings account for 5 years at 5% interest, compounded monthly. His balance ends up being only $29,469.

  Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total
Deposits $0 $0 $0 $0 $0 $5,200 $5,200 $5,200 $5,200 $5,200 $26,000
Interest $0 $0 $0 $0 $0 $121 $393 $679 $980 $1,296 $3,469
Yearly Total $0 $0 $0 $0 $0 $5,321 $5,593 $5,879 $6,180 $6,496 $29,469

Nicky started her saving earlier so she got the benefit of compound interest for the first 5 years. This made a big difference to her final balance. In many cases, even if you double your deposits at a later date, you may never catch up to people who start saving earlier.

Understanding how compounding works will help you to make better decisions on when to start saving and which account to choose.


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Last updated: 31 Oct 2016