Compound interest – a quick guide

Compound interest – a quick guide

If you want to give someone a great insight into money, teach them about compound interest.

Why?

Compound interest is awesome!

Compound interest occurs when:

  • You have an investment that earns interest
  • You add the interest to your original amount
  • You earn interest on the new larger amount

Because you are earning interest on your interest, it essentially pays you a premium for your patience.

How can one not love it?

Taken straight from the Australian MoneySmart website, here is a beautiful comparison:

Simple Interest on a $10,000 investment at 5% per year, taken annually

Year 1 Year 2 Year 3 Year 4 Year 5
Deposit $10,000 $0 $0 $0 $0
Interest $500 $500 $500 $500 $500
Total $10,500 $11,000 $11,500 $12,000 $12,500

Compound Interest on a $10,000 investment at 5% per year (left to compound)If you simply take the interest every year, you will have earned $2,500 in interest over 5 years, and still have your $10,000 starting amount.

Year 1 Year 2 Year 3 Year 4 Year 5
Deposit $10,000 $0 $0 $0 $0
Interest $512 $538 $565 $594 $625
Total $10,512 $11,049 $11,615 $12,209 $12,834

In this scenario, you will earn $2,834 in interest over 5 years. An extra $334 over simple interest.

Not a bad little return simply for being patient.

Note that the maths work in the same way for larger amount too.

If we are to add a couple more zeros to the equation above, starting with $1,000,000, you’d have an extra $33,400.

Here’s a more visual representation of the way compound interest begins to pull away from simple interest, based on the numbers above.

compound interest example

Compounding difference over time

What if we looked at 15 years, or 25 years?

Now we really see the benefits come to life.

Year 15 Year 25
Deposit $10,000 $10,000
Simple interest $17,500 $22,500
Compound interest $21,137 $34,813
Difference $3,637 $12,313

Compound interest benefits come mainly from patience.

Patience allows the investment enough time to really start netting some big returns from earning interest on interest.

It also helps to have a larger starting amount, and high interest rate, and if you can add regular deposits you’ll see the amount skyrocket over time.

It is also a key reason why the rich get richer.

Next time someone asks you for some money guidance, will you bring up compound interest?

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