What is compound interest? Well in very simple terms, it’s the interest you earn on your initial sum of money plus the interest. Basically, it’s earning interest on your interest.
This differs from what’s known as simple interest, which is only paid on the initial or principal sum. For example, term deposits will usually pay simple interest. You’ll get paid interest on the amount you deposit only.
It’s a pretty simple premise but most people tune out when they hear the words ‘compound interest’ or think it’s an investment insider term. We’re here to tell you it’s not, and that you’re already using compound interest to help fund your future (if you have super).
Here’s an example. You have $1,000 to put in a savings account, you’ll earn 10% interest (ha, I wish!) which is compounded (paid) annually. After 12 months your money will have grown from $1,000 to $1,100. Assuming you don’t touch this money and reinvest (just keep saving), your 10% interest will be paid on $1,100 not just the original $1,000 principal sum. In your second year, you’ll have $1,210. Here’s what this could look like after 10 years.
Rather than taking your interest out of the account, you leave it in your account and then you are paid interest on a higher sum of money. You’re simply reinvesting the interest and, in this example, you’re $1,594 or 38% better off.
If you’re able to add money on a regular basis the interest and compound interest will be even higher.
In this example, we still have a deposit of $1,000 but we’re going to add $10 per month.
We’ve contributed an initial $1,000 then added $1,200 but still ended with a balance of $4,506.23 – earnings of $2,306.23.
The examples above are on savings, but compound interest is applied to your super.
Compounding interest works in much the same way for your super as your savings. The major difference being the timeframe, as super is a longer-term investment. When talking about super or investments, the term compound returns may be used.
Your super is made up of a mix of investments, each of these investments should grow and earn you money, which is then reinvested. This then allows you to again earn interest on the interest you’ve been paid. And because super is a long-term investment, and generally money you can’t touch until retirement, the growth can be huge. You can use ASIC’s Money Smart Compound Interest Calculator to see how much you could grow your super by.
Compound interest is the reason so many financial advisers were cautious about recommending taking advantage of the government’s early access to super at the height of the Coronavirus pandemic. Certainly, there were some people who urgently needed the money to live on, but for those that didn’t and took it out just in case, to re-pave the driveway or buy a pool… here’s what we think the losses could have been if you withdrew $10,000:
Calculations are estimations only and will differ depending on individual circumstances, investment choices, superannuation fund performance and other factors. This is a general guide only and should not be taken as financial advice. Assumptions based on retirement age of 65, in an accumulation fund with an average of an 8% return. (source: Australian Services Union)
Compound interest is also applicable to money you have borrowed. When you take out a mortgage you are borrowing the initial amount as well as agreeing to an interest rate. The interest is often compound (applied) daily making the figure you owe larger. This is why paying more than your minimum payment, and paying off your mortgage early, if you can, is so appealing. You’ll have to factor in an exit or early payment fees to ensure this is worthwhile.
Know anyone struggling with credit card debt? This could be because of compound interest. If you’re not paying off the minimum each month then interest is applied, and then applied again on the full amount owing (principal plus interest) the next month. And suddenly, your debt is larger than you bargained for.
Taking advantage of compound interest is pretty simple. You generally can’t touch your super so you’re already using it to grow your retirement savings. And if you have a savings account, try to leave the principal AND the interest for greater growth.
Of course, like any interest or income, you must include compound interest as income to the tax office. This will usually be recorded as part of your interest statements.
It is very important that you understand that the information above is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser. It is also worth noting that the Australian financial and taxation system is ever changing, and the information above may no longer be relevant. Again, we suggest seeking professional advice from a financial adviser before proceeding.