What is compound interest and how does it work
23 January 2019
Albert Einstein is said to have famously described it as the eighth wonder of the world. It has been the source of great wealth for some people and caused persistent debt for others. Compound interest is one of the most powerful forces in finance, yet it is not widely understood or harnessed. Here’s how it works.
In simple terms, compound interest means earning interest on your interest on your interest, and so on.
The Australian Securities and Investment’s Commission’s (ASIC) Moneysmart.gov.au service describes it as like “double chocolate topping for your savings”.
“Compound interest is interest paid on the initial principal as well as the accumulated interest on money you have borrowed or invested,” it says.1 “You earn interest on the money you deposit, and on the interest you have already earned.”
Superannuation is perfectly placed to benefit from compound interest because many people’s money is invested in super for decades, so the compounding effect happens automatically.
ASIC’s Moneysmart compound interest calculator is a good way to try some scenarios and see where compound interest might take you.
Compounding may work in reverse for people with debt.
Mortgage debt is the biggest loan that many people have in their lifetime, and the interest paid can be significantly reduced if borrowers make extra payments and let them compound.
ASIC’s Moneysmart mortgage calculator can help with the number crunching here.
Harnessing the power of compound interest may be a priority for super fund members, investors, savers and borrowers.
As with all money matters, it may be worth seeking budgeting and investment advice around compound interest to make sure this wonder of the financial world works best for you.
You can take control of your finances with the support of financial advice. Have the confidence that comes from working with a financial adviser to help you reach your financial goals.
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The views of the author are not necessarily the views of the QSuper Board. Visit qsuper.qld.gov.au for more information
1 Moneysmart.gov.au guide to compound interest, accessed January 2019
2 ASIC’s Moneysmart superannuation calculator, accessed 1 March 2019. The calculator works for accumulation funds only. It will not work for defined benefit funds. We assume your account balance will receive all income and outgoings mid-year, apart from Government co-contributions which we assume are received at the end of the year. We assume that your employer contributes an amount equal to 9.5% of your ordinary time earnings. We make the following assumptions about investment options and returns: invested in a Growth fund with assumed investment return (before tax and fees) of 5%, investment fees of 0.6% and assumed tax on investment earnings of 5.8%. ASIC advises that these assumed default investment returns and tax rates are based on actuarial advice received in June 2018. Actual returns will vary significantly from year to year and could be negative in some years, particularly for investment mixes where more is invested in shares and property. This calculator does not allow for such variations. Amounts have been rounded.
3 This is a model, not a prediction. Amounts and repayment periods are estimates only, actual amounts may be higher or lower. No account fees are taken into account. It assumes that interest rates do not change for the life of the loan. Interest is calculated by compounding on the same frequency as the repayment selected, i.e. weekly, fortnightly, monthly quarterly or annually. It does not take into account up-front fees such as loan establishment fees.