Compound interest has a snowball effect on money that you invest or borrow: it accelerates your savings. Understanding compound interest can help you make good investment decisions. However, it also accelerates your debts, so a firm grasp of the concept can help you avoid bad debt situations.

What is an Investment?

When you save money in your bank account, you are making an investment decision. Usually, your everyday bank account has a lower interest rate return than other accounts, but you choose to use it because you can easily access your money with minimal fees. Alternatively, you can make your money can work a bit harder for you by choosing a financial product that earns you a higher interest rate. You might choose a high-interest savings account or a term deposit. It’s usually more difficult to withdraw your money if you invest it for a higher return, and there are higher fees for doing so.

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Principal and Returns

The money you invest is called your principal. The money that you earn on the investment is your return. Investors always seek to maximize their returns. Banks encourage you to invest your money with them. When you invest, they lend this money onwards to earn additional fees. There is a continual cycle of lending, borrowing, and repayment between the banks and their many customers. To compensate you for your investment with them and for their use of your money while it's in the account, the bank pays interest to you.

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What is Interest?

The return paid to you by the bank on your savings and term deposits is called interest. You receive this as a percentage of your investment. Imagine you place $100 into your bank account for one year. With a 10 percent interest rate, at the end of the year, the bank will pay you $10 interest. You now have $110, comprised of $100 principal plus $10 interest. Say you invest $100 in the bank for 5 years. You earn $10 interest each year. At the end, you have $150, comprised of $100 in principal plus five lots of interest at $10 each.

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What is Compound Interest?

The simplest way to think of compound interest is that you earn interest on your interest, as well as your principal. Using the previous example, imagine at the end of the first year, you put your $10 interest earning back into your bank account. Your principal for year two now becomes $110 ($100 plus $10). So, your interest earned for year two is $11, instead of the $10 calculated using simple interest. You can see how your money grows more quickly when you earn interest on your interest, as well as your principal.

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Compound Interest Calculation

Your five-year compound interest calculation is:

  • Year 1: invest $100, earn interest of $10; balance at year-end: $110.
  • Year 2: invest $110, earn interest of $11; balance at year-end: $121.
  • Year 3: invest $121, earn interest of $12.10; balance at year-end: $133.10.
  • Year 4: invest $133.10, earn interest of $13.31; balance at year-end: $146.41.
  • Year 5: invest $146.41, earn interest of $14.64; balance at year-end: $161.05.

The amount of interest you earn each year is higher because you earn money on original principal amount plus the interest you earned in previous years.

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Compound Interest and Monthly Payments

Earning interest sooner helps your compound interest accelerate faster. Save your money as early as possible, choose a compounding interest investment method, and seek an option where your interest payments occur more frequently. Deposit $100 on a monthly basis with a 10 percent interest rate, and you'll earn roughly 83 cents interest in the first month. Add this to your principal, and you have $100.83 to invest for the second month, earning roughly 84 cents in interest. The interest you earn is larger each month. By the end of year one, you have around $110.47 in your account.

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Compound Interest and Debt

Compound interest also affects debt, such as credit card balances, car loans, and home loans. Because you pay interest to the bank on debt, you should make your repayments as early as possible and defer interest charges for as long as possible. Otherwise, your debt snowballs in the same way your investments or savings do -- but at the bank's benefit. Avoid this by paying off your credit card balance monthly. Some financial institutions charge interest on the original sum borrowed for the life of the loan, so your interest payments don’t reduce as you repay your debt. Watch for this when you consider loan terms.

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Should I Pay Debts or Save Money?

We know we should always seek to maximize savings and minimize debt, but sometimes it's hard to decide which to do first. Debt usually attracts higher interest rates than savings, so it often makes financial sense to pay your debts before you start saving. There are some cases where you may choose to save first. You may not have access to your money once you use it to pay off debt. When you need money to pay upcoming expenses, it may be better to place it into your savings account. This way you earn some interest before your bills are due. Check the rules and fees for your accounts, or consult a financial advisor to make the best decision based on your situation.

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