Compound interest - definition & overview
What is compound interest and how does it work?
Compound interest is often referred to as "interest on interest". It's basically interest earned on both the initial principal amount you deposit and the accumulated interest from previous periods.
The key difference between compound and simple interest is that compound interest takes into account all the interest earned, not just the initial principal. This can lead to much faster growth over time, especially when considering long investment horizons. The more frequently interest is compounded (daily, monthly, annually), the greater the effect of compounding.
In the context of banking in Australia, compounding interest is commonly used in the following ways:
- Savings accounts: Many Australian banks offer savings accounts that compound interest daily or monthly. This means the interest earned each day or month is added to the account balance, and the subsequent interest payment is calculated on this higher amount. This allows the account balance to grow faster than if the interest was paid and not reinvested.
- Term deposits: Australian term deposits, also known as certificates of deposit (CDs), typically compound interest at regular intervals, such as monthly or quarterly. The compounded interest is added to the principal balance, and the next interest payment is calculated on the new total.
- Loans: While compounding interest is often associated with earning money on savings, it can also apply to loans. Many Australian banks calculate interest on loans using a compounding method, meaning unpaid interest is added to the principal balance, and future interest is charged on the higher amount. This can lead to higher overall interest charges for borrowers.
The effect of compounding interest can be significant over time. For example, if you deposit $10,000 into a savings account with a 5% annual interest rate compounded monthly, your balance would be $10,512.52 after one year. Thanks to the power of compounding, your balance would grow to $16,470.09 after 10 years.
To maximise the benefits of compounding interest in Australia, it's important to choose accounts with competitive interest rates, low fees, and frequent compounding periods. Additionally, making regular deposits and minimising withdrawals can help your savings grow faster over time.
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