You may have heard people say that the sooner you can start saving for the future, the better. But the future can feel so far away, you might not even know what you want to save for. Even so, the advice to save as soon as you can could be worthwhile – and that’s because of compound interest.
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What is simple interest?
Simple interest is the interest on the amount you put in savings, at a set rate. This means that you earn a percentage on top of what you put in. For example, if you save $1000 and earn interest at a rate of 2.5% over 10 years you would have 1,250.00. Simple interest is usually calculated on your balance daily, then paid to you every four weeks, six months or year.
Interest on some term deposits is paid at the end of the term. While some term deposits come with compound interest, most come with simple interest. Your bank pays the interest you earn either every year or at the end of the specified term.
What is compound interest?
Compound interest is the interest on earned on your interest. This means that you earn a percentage on top of both what you put in as well as the interest you earn on that amount. For example, if you save $1000 and earn interest at a rate of 2.5% over 10 years you would have $1,280.08 interest, compared to $1,250 when you only earn simple interest.
So you earn interest on:
- The amount you put in savings, which is known as the principal (the $1000)
- Interest you earn, which is usually paid to you monthly
The interest is usually calculated on your balance daily then paid into your account each month.
Making the most of compound interest
Most savings accounts come with compound interest. So even after two months, you will have earned interest on both the amount you put in savings, plus on the interest you were paid in the first month.
The higher the interest rate for a savings account, the better. And if you keep your savings in your account for some time, the power of compounding can grow your money over time. Saving money regularly can allow you to earn more interest.
Use a savings calculator to get an estimate of how much compounding you can benefit from. Or do the maths yourself with help from a formula provided on the ASIC MoneySmart site.
