How Does Compound Interest Work?

Posted on 19. Oct, 2012 by in Creating Wealth

Compound interest

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it. – Albert Einstein

I was having dinner with some great friends the other night when conversation somehow moved onto compound interest. Naturally I became overly excited and showed what many would think is a rather unnatural amount of passion for a topic that most don’t really seem to dwell on for too long, or really even understand.

Fortunately I’ve managed to reign back some of my excitement these days, so I tried not to launch into a long winded explanation about how magical compound interest was, but given there was a little confusion I attempted to clarify things the most efficient way I could.

Compound interest is simply a term that describes the result of the interest that you earn on your interest.

Still confused? we can fix that

Right now in Australia you can comfortably get a 5% return on a 6 month term deposit, which is a nice number for us to work with. What that means is that if you left $1,000 in the bank for 6 months you would end up with $1,050. That is $50 for doing absolutely nothing.

The next part is where the magic happens, if you roll the entire amount over for another 6 months you earn another 5%, so your total after 12 months is now $1,102.50.

Se where I’m going with this? This time you earned $52.50, without doing anything differently. That is because you were earning interest on the amount you put in to start with, plus on the interest from the last period. Big deal right? $2.50 won’t even get you a cup of coffee these days. The real key to compound interest is time (and compound frequency), if you leave that money in the bank and come back in 10 years that $1,000 has turned into $2653.29. Which means that you have made $1653.29 without lifting a finger. Without compound interest, you would have only made $1,000 ($100 per year for 10 years).

Still not impressed? Try adding a zero on the end. If you did the same amount with $10,000 over 10 years you would have made over sixteen thousand dollars, you could buy a coffee a day for the next 12 years with that.

Want to see something even cooler?

Let’s say you decide to embrace the concept of compound interest and put away $5,000 a year ($100 per week) for 10 years, we’ll call it a homestart fund for your child when they turn 25 and you start at their birth. If you earned 10% interest, you would have  $86,476.86 for a $50,000 investment, not too bad. After the initial 10 year period your child goes to a private school and you can’t put money away anymore, but you do leave the account with the balance as things stand. By the time your child turns 25, there is $361,235.31 in the account waiting to kick start their future. BAM! – you just made over $300,000 from a $50,000 investment (yes, there will be some tax to pay, but let’s worry about that another time).

Want to see what happens when you don’t embrace it early?

Let’s say that you wait for the first 10 years, then put away $5,000 each year until your child is 25. Effectively you have contributed half as much again to the savings account over a 15 year period, but on your child’s 25th birthday they get a total of $195,634.89. You paid 25K more out of pocket, but your child gets $150K less – OUCH!

Time is super important to wealth creation, learn to use it to help you. Think very carefully about these scenarios in reverse and consider what the bank gets from you over time when they charge interest on your loans – don’t lose sight of that.

How have you used compound interest to help you and how do you combat its use against you? 

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4 Responses to “How Does Compound Interest Work?”

  1. Jon @

    22. Oct, 2012

    I have always loved that Einstein quote but I can’t believe I had never heard the last part of it “he who knows it earns it…he who doesn’t pays it”

    Not sure I agree with giving an adult child a 350k kickstart but understand it was just an example 😉

    • Money Cactus

      22. Oct, 2012

      Hey Jon,

      I think it is a really good quote too. Some might like the idea of giving their kids such a big leg up, particularly as the hope of owning your own home is becoming increasingly more unattainable for young people (particularly in Australia), but it could also be one hell of a holiday / mini retirement or just about anything else you want really.

  2. LOL, you just took me back to my high school math classes. I remember the “e” being part of the mathematical formula, but that’s about it!

  3. Jane

    04. Nov, 2012

    Interesting! I never thought of it that way, but yeah I agree it could become a good investment. Thanks for sharing this!