May 22, 2019 | 05:59 AM


23.08.2018How does compound interest actually work?

Compound interest is something that many people have heard of but not many people fully comprehend. Read our guide n FatCat.com.au.

Compound interest is something that many people have heard of but not many people fully comprehend. For those who have savings locked away somewhere for a long period of time, it’s likely that compound interest has been largely responsible for fuelling their growth. It’s a neat little mathematical phenomenon which improves the return on investment of many financial products and other instruments, and which often leaves savers with a pleasant surprise when they check their statements at the end of the year.

What is it?

Put simply, compound interest is the result of a few sums. It’s the total interest a person receives on an untouched investment over a period of time – but rather than simply calculating the interest rate percentage of the initial deposit and adding it on, compound interest takes into account the reinvested interest from previous years on a rolling basis.

Say, for example, that an investor had $50,000 to deposit in a scheme which paid out 5% per year. After the first year, the investor would (provided the market hadn’t turned against them) have their initial $50,000 plus 5% of that in interest, which is $2,500. In total, they’d have $52,500.

When it came to calculating the interest for the second year, though, they wouldn’t just get 5% of $50,000 again like they did last year. They’d instead get 5% of the new total deposit amount, which including last year’s interest would have been $52,500. 5% of $52,500, then, is $2,625 – which means the interest is even higher than it was last year. Over time, this can really add up!

Why reinvest?

The important thing to note about compound interest is that it only accrues when the investor makes the decision to reinvest their interest each year. Sometimes taking out the interest rather than reinvesting it makes sense. For those with very large deposits, the interest payments can occasionally be big enough to act as a salary – and taking the interest to cover living expenses rather than reinvesting it can even mean there’s no need to work anymore.

As for those who are struggling for cash but don’t want to dip into the principal savings, taking the interest to help ease money worries can be a good compromise. For those who are saving for no fixed purpose other than savings growth and don’t need the money, reinvesting in order to access compound interest is a very smart move, and it’s one that pays off big financial rewards in the long run.

Wider strategies

Compound interest shouldn’t be relied upon as a sole way to grow a pot of cash. That can only come from using a whole host of different methods at once. It requires a good interest rate, and in order to locate that a saver should always be shopping around for the best financial products. It also requires some capital to go into the pot in the first place, and to continue to go in over time. Making a regular payment out of a pay check and into the savings account is a shrewd move. But as part of a strategy which incorporates lots of different capital growth methods, it’s possible for compound interest to really turn a saver’s fortunes around and give them a fighting chance of developing a bigger pot for whatever goal they may be trying to reach. 

While on the face of it compound interest may seem difficult for a consumer to comprehend, it’s really not that hard. In sum, it relies on having the power to wait more than mathematical knowledge. Provided the interest rate is good, time will work its magic and the compound interest will appear. While in some circumstances taking the interest out upon payment and forgoing the compound interest may make sense, in most cases it’s a great phenomenon to take advantage of.

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