How does compound interest work?

Compound interest is simply earning more interest on your interest. Meaning that your savings grow faster when interest is left to compound over time. A common example is a bank account that pays interest on money you have in this account and where you leave the interest to accumulate in the account and earn more interest.

For example, let’s say you have $10,000 in an account that earns 5%pa interest. If the interest rate remains at 5% for the year then at the end of the first year, it will have earned $500 in interest. If you leave that interest in the same account and it’s still earning 5% interest, then in the next year you will be earning interest on $10,500 and will have earned $525 at the end of the year.

Doesn’t sound like much of a difference now but that’s because the real power of compounding interest lies in time. The longer you leave the deposit and interest accumulating the more you will earn. Let’s take our example and extend it out over time.

Let’s say it takes you roughly 10 years in the workforce to save that initial $10,000 and that at age 30 you deposit it into a retirement savings account that you don’t touch until age 65. Over that 35 years, with interest at the same rate of 5%per year, your $10,000 will have become a little over $55,000. Not bad considering you haven’t done anything other than not touch your money.

Given time is the critical element here, what if you had been able to save that $10,000 sooner and actually been able to deposit it into your retirement savings account 10 years earlier at age 20? Well, over 45 years, assuming the rate stays at 5%per annum, your $10,000 deposit would have turned into nearly $90,000 without you having done a thing.

Let’s add to that … if you’re also able to add $1,000 savings per year over that 45 years …your $54,000 of savings, at 5% per annum unchanging, would have earned you almost $195,000 in compound interest by the time you reach age 65 … meaning that you have almost $250,000.

To make the most of compound interest, start early and continue to add and reap the rewards over time. Curious to know more about your finances? Have a look at the other range of Davidson Institute financial education resources on their website.