Compound interest: what it means for you  

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Team MONEYME|07 May 2024| 2-minute read

If you’re taking out a loan or saving money, then it’s crucial to understand compound interest. It could have a serious impact on your financial future.  

Here, we delve into what compound interest is, how it works and what it might mean for managing your money.  

Compound interest on loans 

When you take out a loan, the amount you initially borrow is called the principal. On top of this, you usually pay interest, calculated at a certain rate per annum, such as 5%. This rate often changes from year to year.  

Compound interest is the interest you pay on both the principal and the interest.   

Compound interest on savings  

Compound interest on savings is similar – except you earn the interest, rather than paying it. The amount you initially deposit is called the principal. If you invest your deposit – in a high-interest savings account or term deposit, for example – you usually earn interest at a certain rate per annum, such as 5%. This rate can change from time to time.  

Compound interest is the interest you earn on both the principal and the interest.   

How does compound interest work? 

Say your principal is $100, and the interest rate is 10% per year. At the end of the first year, the amount would increase to $110 – made up of $100 principal and $10 interest. 

If compound interest were applied, then the amount of interest added at the end of the second year would be 10% of $110 (both the compound and the interest). That’s $11. So, the total amount would grow to $121.  

This would apply every year, so that, after 20 years, $100 would become $733 (without any other deposits being made). 

Compound interest v simple interest  

In contrast, simple interest is paid only on the initial amount.  

To continue with the example above, the $100 would increase by $10 every year. After 20 years, it would grow to $300 – less than half the amount it would reach were compound interest applied. 

How might compound interest impact your finances? 

If you’re borrowing money and paying compound interest, to reduce the overall total, consider repaying your loan as quickly as you can (depending on any early exit fees). You could make extra or more frequent repayments, or occasional lump sums, such as by using your tax return. If you have a credit card that incurs compound interest, try to pay it off in full each month, or at least repay more than the monthly minimum whenever possible.     

If you’re saving, then earning compound interest could help you to improve your financial future – because any money invested today will be worth more in 10 years than it is now. To maximise the benefits, leave as much of the principal and accrued interest in your account – without touching it. This could be an excellent option for a long-term goal, such as saving for a house deposit.