Compound interest: what it means for you

Whether you're borrowing money or saving it, understanding compound interest is important. It could have a major impact on your financial future.   

In this blog, we’ll break down what compound interest is, how it works and what it could mean for your money.   

Compound interest on loans and credit cards 

When you take out a loan, the amount you borrow up front is called the principal. On top of that, you typically pay interest, which is calculated at a certain rate per annum, such as 5%. If it’s a variable rate loan, this interest rate can change up or down with the market.  

For credit cards, the equivalent to a loan principal is the amount you borrow through your card transactions. Many credit cards have an interest free period, but after that, you would begin to pay interest on your credit card balance. 

Compound interest is the interest you pay on the interest that has been charged on the original amount you borrowed over time. In other words, compound interest is when you pay interest on interest.  

Compound interest on savings   

Compound interest on savings is similar – except you earn the interest, rather than paying it. The amount you initially deposit is called the principal. If you invest your deposit – in a high-interest savings account or term deposit, for example – you usually earn interest at a certain rate per annum, such as 5%. This rate can change from time to time.   

Compound interest is the interest you earn on the interest that has already been earned and added to the original principal balance over time.    

How does compound interest work?  

Let's say you start with $100 in your savings account, and the interest rate is 10% per year. At the end of the first year, your total would be $110, which is your $100 principal plus $10 interest. 

If compound interest is applied, then the interest for the second year would be 10% of $110 (both the principal and the interest). That’s $11, so your total would grow to $121.   

This would apply every year, so that, after 20 years, your $100 would grow to about $733, even if you don’t add any more savings to your account.  

Compound interest v simple interest   

Simple interest, on the other hand, is only calculated on the initial amount.   

Using the same example, your $100 would earn $10 each year. After 20 years, your total would be $300 – which is a lot less than what you would get with compound interest.  

How can compound interest impact your finances?  

If you’re borrowing money and paying compound interest, you can save money in the long run by paying off your loan as quickly as possible (if there are no early exit fees). You could make extra repayments, pay more often, or even throw in occasional lump sums, like your tax return. If you have a credit card that incurs compound interest, try to pay off the full balance each month, or pay more than the minimum due whenever possible.      

On the flip side, if you're saving, compound interest can really boost your financial future. Money you invest today will be worth more in 10 years. To get the most out of it, leave as much of the principal and earned interest in your account as possible. This can be a great strategy for long-term goals, like saving for a house deposit.