Sprinkles on ice cream, ketchup on hot chips and interest on interest – some things are better with a little extra on top.
If you're looking to grow your money faster and reach your savings goals sooner, a compound interest savings account could be your new best friend. It's the kind of topping that keeps giving – earning interest on your interest, again and again.
What is compound interest?
A compound interest savings account is a smart way to grow your money faster over time. Unlike simple interest, which only pays you on the amount you originally deposited, compound interest pays you on both your initial deposit and the interest you’ve already earned.
Here’s what that means in practice:
- You earn interest on the money you put into your savings account (called the principal).
- You also earn interest on the interest that’s added to your account.
- Interest is usually calculated daily and paid monthly, so your balance keeps growing even if you don’t contribute any extra principal.
So, you’re probably wondering ‘OK, great – but how much is compound interest?’.
Here’s an example to help explain: Say you deposit $1000 into a compound interest savings account, with a rate of 4.1 per cent over 10 years. You’d earn around $491 in interest, compared with $410 using a simple interest account.
The initial difference might seem modest, but over time, compound interest accumulates dramatically.
The differences between simple interest and compound interest.
Traditional interest (known as simple interest) is interest you may be more familiar with. It’s where you only earn interest on the money you deposit into your savings account. A term deposit is an example of an account that earns simple interest over a fixed term.
If you’re borrowing money (including loans and credit cards) simple interest is better. You’ll be charged interest on the initial amount only, so you can clear the debt sooner.
But when your goal is to save money, it pays to have a compound interest savings account. Most savings accounts automatically compound interest, so the interest you earn is added to your balance, and each subsequent interest calculation is based on a larger total.
Over a long period – say, 30 years – this can yield exponential growth, making compound interest a cornerstone of a solid, long-term savings strategy. The earlier you start, the better.
How to calculate compound interest.
If you want to make your money work harder, a compound interest savings account can be a smarter way to beef up your nest egg.
Here’s a simple example to show how it works:
- You deposit $200 every month into a savings account.
- After 5 years, you’ll have contributed $12,000 in total.
- If your account earns compound interest monthly, you could end up with $12,768.
- That’s $768 in extra savings from interest – without lifting a finger.
How? You earn interest on the $12,000 as well as the interest paid into your account – that’s money for doing nothing, nada, zilch!
To understand the formula for compound interest and how much you could earn, check out the MoneySmart compound interest calculator.
Get the most out of your compound interest savings account.
While most savings accounts automatically compound interest – and a higher interest rate generally means better returns – there are a few key strategies to help you make the most of it:
Choose the right account.
- Look for a high interest savings account that compounds frequently. Your interest could compound daily, monthly, quarterly, half-yearly or annually – but the more often interest is compounded, the more money you’ll earn. The magic of compounding comes from both your original savings and the interest that’s already been added.
- Compare account types, such as savings accounts vs. term deposits, and review their interest rates and compounding frequency.
- If you do choose a savings account, try to find one with no monthly fees or confusing criteria to gain interest.
Deposit regularly and minimise withdrawals.
- Keep adding to your savings. The more you contribute, the more your interest compounds.
- Try not to withdraw often – some accounts reduce your interest rate if you make withdrawals.
Take advantage of bonus interest.
Bonus interest is an extra interest rate added on top of the base rate when you meet certain conditions. These types of savings accounts ensure your money works harder so you can reach your financial goals sooner.
The bonus conditions might include:
- Making regular monthly deposits.
- Not withdrawing.
- Maintaining a minimum balance.
Set clear goals and use tools.
Watch your savings stack up with SaveME.
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This article is prepared based on general information. It does not take into account individual financial objectives or needs and is not financial product advice.