Learn how compound interest can help your money grow

How compound interest works

If you save $100 at 10% interest, after a year you have $110. The next year, your $100 earns another $10 – and the first $10 of interest also earns $1 interest of its own. So your balance grows to $121, not $120. The extra might not seem like much at first, but after three years you’ll have $133. And so on, until after 10 years your $100 has become $259 – which is $159 just from compound interest.

Compounding works for all types of investment returns, not just interest on savings in the bank. So you can have compound returns as well as compound interest.

The earlier you start, the more your money grows

Let’s say you invest $2000 each year (into an aggressive investment fund of mostly shares, earning the same average annual return of 5.5%). If you start at age 18 and stopped at 41 you’d see your money grow seven times to $362,562 at age 65.

If you instead wait until age 42 to start investing, you’d still have invested $48,000 over 23 years. But you would end up only doubling your money to $100,305 by age 65.

Use compound returns to keep ahead of inflation

Do you remember when you could get a big block of cheese for just $8? Or maybe your parents or grandparents talk about how cheap things used to be? Prices tend to increase, and they’ve gone up a fair bit through the years.

As prices inflate and things get more expensive – whether it’s food, petrol, housing or cars – our money buys less and less. That’s inflation.

Although we may have cash stashed away, it’s losing value all the time, like sand slipping through our fingers. This can make it challenging to save for long-term goals.

How can we build up enough to stay ahead of inflation?

One way is to invest so our money grows through compound returns. Ideally we want the rate of return to be higher than the rate of inflation.

Take advantage of compound returns for your long-term goals

Investing is the way to make the most of your money and reach your long-term goals – things that are 10 years or more in the future.

If you’d like to give this a go, check out our guide to help you get started, and our tool to work out your investor profile.

If you’re in KiwiSaver, you’re already an investor. The money we put in is invested in assets (types of investments like shares and property) managed by professionals, and the returns compound each year. This is why it works so well for long-term goals such as retirement or buying your first home.

The benefits of compounding also continue during retirement on the money you don’t withdraw straight away, helping make your money last longer.

To get an idea of what you are on track to achieve in KiwiSaver in the run up to retirement, or to see how long your money will last once you’ve stopped working, try our KiwiSaver calculator.

The earlier we start, the more we make

The longer we leave our money, the more powerful the compounding interest effect. So the earlier we start saving, the more we make from compound interest (of course, only if we don’t withdraw the interest).

The same applies to other investments such as shares, where we regularly reinvest dividends, or when the company reinvests its profits. 

Debt can compound too

Compound interest also applies to debt – although not in a good way. Costs can compound too. The slower we repay a debt which charges interest, the more we end up paying back over time.

So the choice is to have compounding interest work for us or against us, and unfortunately the effects can be devastating if we’re always on the wrong side of things.

If you're dealing with debt, take a look at the managing debt guide.

Compound interest in action

The table below shows the power of compound interest working for us. The results are based on an interest rate of 2.5% after tax and allowing for inflation.

It also assumes that we’ll increase the amount we save each week to account for inflation. So if inflation is 2% this year, we’d increase our weekly savings by 2% from next year (from $50 to $51).

Look at the first five years and the last five years of the table. In the first five years we save $2,600 and earn $170 in interest. In the last five years, we’re still saving only $2,600, but earn a massive $3,970 in interest – far more than we save. That's the power of compounding interest!

For example saving $10 a week from the age of 20

If we start saving $10 a week when we’re 20, by the time we’re the age in the left hand column we’ll have saved the amount in the right hand column.

Double your savings

There’s an easy rule we can use to work out how our savings or investments can grow with compounding interest.

Divide the number 72 by the interest rate (or average annual return).

The result shows how long it will take for our money to double without further savings.

For example, take $10,000 that is earning 6% interest (after tax). 72 divided by 6 = 12.

Every 12 years that $10,000 will double, so:

• After 12 years we have $20,000
• After 24 years we have $40,000
• After 36 years we have $80,000

To be completely accurate, we would need to reduce the interest rate to allow for inflation. For example, if we allowed for 2% inflation, the real interest rate would be 4%.

Sound complicated? This savings calculator does all the maths for us.