Albert Einstein dubbed compound interest the eighth wonder of the world. “He who understands it, earns it. He who doesn’t, pays it,” the man commonly considered a genius once said.
Put simply, compound interest is earning interest on your interest income. The Australian Investors Foundation describes it as “a fundamental component of wealth creation” and it’s something investors use to their advantage – by reinvesting the interest they earn on an investment, they earn more interest on the growing amount.
For example, investing $10,000 in a managed fund earning 12 percent per year could give you a total return of $31,058 at the end of 10 years. That’s an impressive $21,058 earning on top of your initial investment. If, however, you choose to have the interest paid to you at the end of each year, you would only earn a total of $12,000 in interest.
Making compound interest work for you
But you don’t have to venture into the world of managed funds or shares to benefit from the power of compound interest. The simplest way to use compound interest to your savings advantage is through a high interest savings account.
The interest you earn is added to your account balance, growing the balance beyond any additional deposits you make. Each time interest is calculated, it is done so on the larger amount – earning you more interest each time.
“It’s the idea of regularly putting money aside and using the growth or the interest to grow the investment or savings,” says Steve Crawford, owner of Experience Wealth and Victorian director of the Association of Financial Advisers.
Time is the key to compound interest – the longer you allow your savings to compound, the better off you will be. This is why financial advisers recommend to start saving as early as possible; even small amounts a week can make a huge difference.
The ugly side of compound interest
Unfortunately, there is also a bad side to compound interest – it’s what makes credit card debt so hard to pay off.
Unless you pay off your credit card balance in full each month, the interest is added to the amount you owe and you end up paying interest on the interest. And this continues each month, with interest calculated daily.
The power of compound interest can help you grow your savings, or land you in growing credit card debt. Use it to your advantage.