How does compound interest work and why is it so good?

Compound interest is money building on money. It’s the outcome of choosing to reinvest your earnings, instead of spending them.

If you start with $10,000 and put it in a 12 month Term deposit paying 4% for example, you will make $400. Assuming you reinvested your income and rolled it over for a second year at the same rate, you would make $416, because you’ve made 4% on the larger sum of $10,400. Over time this builds exponentially and depending on your return achieved, the power of compounding can deliver significant upside in a relatively short period of time.

Looking at an example, we’ve compounded the growth of your money, with a return of 4%, 7% and 9% over a 10 year period.
 

 
 
Interest Rate Total Return - Compounded
4% 48%
7% 97%
9% 137%

Comparing this to the equivalent ‘simple’ return, which is the assumption you withdraw the earnings and don’t reinvest them, the equivalent total return over 10 years would be:

Interest Rate Total Return - Compounded Total Return - Simple
4% 48% 40%
7% 97% 70%
9% 137% 90%

From these examples you can see that the difference between simple return and compound return is exponentially larger. 

To illustrate this in another way, the earning factor that doubles money over a 10 year period is 7.2%. If this return can be maintained at 9% pa, then your money will double every 8 years. These effective returns are known broadly as ‘the factor to double money’.

The other thing to recognise with compounding is that the higher the start value, the greater the compounding benefit. It’s due to this that borrowing to invest can be a great wealth creation strategy. 

 
 

GENERAL DISCLAIMER:

The content of this presentation is intended to be general information only and has been prepared without taking into account any person’s objectives, financial situation or needs. Each person should consider its appropriateness having regard to these matters or obtain relevant professional financial advice before making any financial decisions.  Examples are illustrative only. Each person should obtain any relevant professional financial, taxation and social security advice before making any financial decisions.