If your goal is to save for the future, or perhaps start putting away for your children’s education - then unless you plan on putting your savings under your mattress, the sooner you start the better.
That’s because you could be missing out on earning compound interest along the way that could make a stark difference to the overall amount you save.
The difference between simple interest and compound interest
Simple interest is where a one-off interest payment is made at the end of an agreed, set period of time.
For example: if you invest $10,000 in a term deposit at 5% interest per annum, and don’t withdraw any money, then you’ll have $12,500 at the end of 5 years. That’s because the 5% annual interest rate is worked out based on the value of the initial investment and paid in full at the end.
Simple interest earnings over five years
Compound interest is where interest is paid in regular intervals, building on top of earlier interest paid. The result is a snowball effect of interest earning interest.
For example, (using the same figures as the simple interest example above), an initial investment of $10,000, earning 5% interest per annum with compound interest paid monthly, will give you $12,834 after five years. That’s because every month the interest earned was earning more interest.
Compound interest earnings over five years
Compound interest will continue to build on itself in this way, assuming nothing changes. How quickly it grows will depend on when you start your savings plan, what the interest rate is, and whether you make contributions (or withdrawals).
It can help your savings grow faster than simple interest. It's when interest earned on savings is reinvested, building on top of earlier interest received. The result may lead to a snowball effect of interest earning interest.
One potato, two potato, four potatoes, eight potatoes, sixteen, thirty-two, sixty-four - that’s a lot of potatoes! And that’s what happens when you compound a potato. But what happens when you compound money? Well, to know that, let’s first look at what is compound interest.
Compound - or compounding interest, is interest that is paid on both the principal - the money you have - and also on any previous interest this principal amount has earned. It most commonly appears when people reinvest the interest they get, back into the original investment or principal. Basically, compound interest is earning interest on interest.
So, let’s say you have a $1000 investment and earn 10% interest on it in the first year, and then that interest is reinvested into the original investment. In the second year, you would earn interest on both the original investment and the interest, so you earn a further 10% on the whole sum of $1100. Over time, compound interest will make much more money than simple interest -which is interest earned on the original amount only.
So, why not start thinking about how you can use compound interest to your advantage? Talk to your financial provider or seek financial advice.
Now… what am I going to do with all these potatoes?
How to work out compound interest
The easiest way to work out how much compound interest you could earn on your savings, is to use an online compound interest calculator, that can do it for you.
Saving for the future
If you’re interested in using compound interest to help your savings grow, then the sooner you start, the better. That’s because, like any good snowball, the earlier it starts rolling, the more snow it will collect along the way.
For example, if you were keen to put aside money for your child’s education, and from the day your child was born, you put $10 per week into a bank account paying 6.25% pa, then by the time they turned 25, their savings would be $31,259. Of that, the interest earned would be $18,372 - outweighing the overall deposits made along the way.
If you started saving later, when your child turned 10, with a first deposit of $5,000, then by the time your child turned 25, they would have savings of $25,611. Of that, the interest earned would be about equal to the overall deposits made, and your savings would be about $6,000 less than if you’d started earlier, without an initial deposit.
This example uses the ASIC Money Smart Calculator1 featuring an effective interest rate of 6.43%. It’s important to remember that a model is not a prediction and uses assumptions. Results are only estimates, the actual amounts may be higher or lower.
Tax on compound interest
It’s worth remembering that like any income, compound interest earnings must be declared to the tax office, even if it’s savings for a child. Who declares the interest earned, depends on who owns or uses the funds of that account. You can find out more about the tax requirements from the Australian Tax Office.
1ASIC Money Smart Compound Interest Calculator - https://www.moneysmart.gov.au/tools-and-resources/calculators-and-apps/compound-interest-calculator
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