Basics of compound interest

Compound interest is an important concept in the financial world. In simple words, it means that you earn interest on your principal amount as well as on the interest earned from the principal amount. It is slightly different than normal interest, in which you only earn interest on the initial principal amount or deposit.

Time is really of essence when it comes to compound interest as you reap the benefits in the long term which means that the longer your money is invested, the more time it will have to grow. It especially works well if you are saving for the long-term, that is retirement, or towards your medium-term goals like a first home deposit. In these cases, the earlier you start, the more you would be able to save for these goals. Compound interest works well in situations where there is rising inflation and cost of living which eventually decreases your buying power over the years.

For example, imagine you invest $10,000 in a term deposit for five years that earns you fixed returns of 5% annually, at the end of that year, you will receive $500, meaning you now have $10,500 in your account. If you keep that $10,500 invested in your account then by the end of the second year, you will earn $525, that’s $500 for your principal amount and $25 on the interest you earned in the first year. If you keep the money invested as well as make extra contributions, it will exponentially increase your earnings over the long term. KiwiSaver and other superannuation schemes incorporate compounding interest in the returns as you cannot withdraw your funds before your retirement which makes your money grow over the years. 

The Sorted website has a great tool to find out how compound interest makes your savings grow over the years: Savings Calculator » Sorted

This information has been prepared by Mercer (N.Z.) Limited for general information only. The information does not take into account your personal objectives, financial situation or needs.

22 June 2023