We’ve all heard the famous quote attributed to Albert Einstein:
“Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pays it.”
Understanding the power of compound interest can mean the difference between financial freedom and financial stress. It can help you accumulate wealth over time while ensuring you avoid unnecessary interest costs on loans.
But what exactly is compound interest, and why does it make such a difference? Let’s break it down in simple terms and explore how it applies to the everyday Australian.
What is compound interest?
A good place to start is understanding the difference between simple interest and compound interest:
- Simple Interest is calculated only on the original amount (or principal) of a loan or investment.
- Compound Interest is calculated on the principal plus any interest that has already been added to it. This means that over time, interest earns interest, causing growth to accelerate.
The best way to illustrate this is with real-world examples.
The cost of compound interest on loans
When Einstein said, “he who doesn’t understand it, pays it,” he was referring to how compound interest works against you when you borrow money.
Case Study: Paying off a home loan in Australia
Let’s say you take out a $500,000 mortgage with an interest rate of 5%, and interest is compounded monthly. The repayment term makes a huge difference in what you actually end up paying.
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- Paying it off in 20 years: Your total repayments will amount to $791,947.
- Paying it off in 30 years: Your total repayments will amount to $966,279.
That’s an extra $174,332 paid in interest just because you took 10 more years to repay the loan! This is why financial experts recommend paying off debt as quickly as possible—every extra dollar paid early reduces the amount of interest that can compound.
The power of compound interest when you’re earning it
Now let’s look at how compound interest can work in your favour. When you invest your money wisely and let interest compound, your wealth can grow exponentially.
Case Study: Investing for the long-term
Imagine you invest $100,000 in a high-interest savings account or diversified investment fund earning 5% per year, compounded annually.
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- After 5 years: Your investment grows to $127,628.
- After 20 years: Your investment grows to $265,330.
- After 30 years: Your investment grows to $432,194.
The difference is staggering—after 30 years, you would have made over $332,000 in gains, simply by letting compound interest do its job.
This highlights a key lesson: the longer your money is invested, the greater the benefit of compounding. The earlier you start, the more powerful it becomes.
Practical tips to make compound interest work for you
If you want to harness the power of compound interest, here are some key steps you can take:
- Start investing early – Even small amounts invested early can grow significantly over time.
- Pay off debt as fast as possible – Avoid paying excessive interest by making extra repayments where you can.
- Reinvest your earnings – Let your interest and investment returns compound instead of cashing them out too soon.
- Be consistent – Regular contributions to your investments or superannuation can have a significant impact in the long run.
- Make use of tax-efficient investments – Superannuation contributions, for example, can provide tax benefits while also benefiting from compounding growth.
Final thoughts
Understanding compound interest means you can use it to your advantage rather than letting it work against you. Whether it’s minimising loan interest or maximising investment returns, the impact over your lifetime can be worth hundreds of thousands of dollars.