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When you’re saving, the bank (or financial institution) adds interest to your savings at regular intervals (for example, every month). If you don’t touch the interest, but let it add to your lump sum, then you start to earn interest on your interest, as well as on the original amount you saved. This is called compound interest.
The longer you leave your money, the more powerful the compound interest effect. So the earlier you start saving, the more you make from compound interest. The same applies to other investments such as shares, where you regularly reinvest dividends, or the company reinvests its profits.
Consider the example of Viv. Viv’s a 20 year old who decides to start saving a regular amount each week. The tables on the next screen show how much she will end up with if she keeps up her saving (either $10 per week or $50 per week) until she is 60. We’ve based Viv’s results on an interest rate of 2.5% after tax and allowing for inflation.
We’ve also assumed that Viv will increase the amount she saves each week to account for inflation.
If inflation is 2% this year, Viv will increase her weekly savings by 2% from next year (from $50 to $51)
Look at the first five years and the last five years of the $10 table. In the first five years Viv saves $2,600 and earns $170 in interest. In the last five years, she’s still saving only $2,600, but she earns a massive $3,970 in interest – far more than she saves. That’s the power of compound interest!
Saving $10 per week from the age of 20
Saving $50 per week from the age of 20
The Rule of 72 There’s an easy rule you can use to work out how your savings or investments can grow with compound interest.
Just divide the interest rate (or average annual return) into 72. The result tells you how long it will take for your money to double without further savings.
For example, you have $10,000, which is earning 6% interest (after tax). 72 divided by 6 = 12. Every 12 years your $10,000 will double, so:
To be completely accurate, you would need to deduct something from the interest rate if you wanted to allow for inflation. For example, if you allowed for 2% inflation, the real interest rate would be 4%.