Compounding interest helps supercharge your savings. You earn interest on your balance which makes your balance bigger.
When you get interest on a bigger balance, the dollar value of the interest is also bigger. Which makes your balance even bigger, and so on.
Let’s look at a scenario to help us understand how compounding interest works – putting $10,000 into a savings account, earning 10% interest p.a (per annum meaning each year).
Note: this is an extremely unrealistic interest rate for a savings account, but to help us unpack the power of compounding interest we are using these numbers.
At the end of the first year, you would have earned $1,000 interest but at the end of the second year, you would have earned an extra $100. This is because with compounding interest, you earn interest on the full amount – the $10,000 original investment plus the $1,000 interest from the first year. So you get $1,100 interest.
Have a look at this table to see how interest builds on itself (i.e. how it compounds) over time:
It may be hard to believe, but this is the power of compounding interest. Remember you only put in $10,000 but, due to compounding interest, you have earned $164,494.02 by Year 30, making your total balance $174,494.02. Remember this is a very unlikely scenario and we’ve used it only to make the maths, and the concept, easier to understand. But it still shows why investors say time is your best friend when it comes to compounding interest.
Another way to look at it is, the $10,000 you had at Year 1, is now worth $174,494.02 at Year 30.
Have a look at how much you would have by the end of Year 50.
Famous physicist Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it earns it and he who doesn’t… pays it” What did he mean?
Remember, there is interest on borrowing too. Let’s have a look at this scenario.
You purchase something worth $10,000 with a credit card, the interest rate on this is 19.95% p.a. You are unable to make any repayments, but you don’t spend any more either.
Note: right now most credit card interest rate is 19.95% p.a on purchases and 21.96% p.a on cash advance.
By the end of Year 1, your credit card balance has gone up to $11,995, an extra $1,995 even though you didn’t make any additional purchases. How quickly will this go up? Have a look what happens by the end of Year 5 (again assuming you make no repayments).
Although you only borrowed $10,000 using your credit card, by the end of year 5, you owe $24,831.40. Not fair right? What is even more crazy is in real life, it is likely that you would be charged more if you made no repayments because it is unrealistic to be charged credit card interest annually. Normally you are charged interest on a monthly basis and interest is incurred on your daily balance until it is paid in full.
Again, we have used this scenario to make the maths, and concept easier to understand. This is why it is important to understand the power of compounding interest and, just as important, to be very careful about getting into high interest debt and to pay it off as much as you can, as often as you can.
Published 16 October 2019
By Clara Kim, registered teacher and JUNO's educator
Pie Funds Management Limited is the issuer of the JUNO KiwiSaver Scheme. You can read our Product Disclosure Statement here. This article is general in nature only and has not taken into account any particular person’s objectives or circumstances. We recommend you speak with a financial adviser before relying on the content. All content is correct at time of publication date.