Imagine a snowball rolling down a mountain. As it travels downward, it picks up more snow and gets bigger. What do you expect to see by the time the snowball reaches the bottom of the mountain? Yep, a giant f*ck-off sized boulder of snow.
What does a snowball have to do with compound interest?
The snowball is an analogy of what happens to money you save over time.
Money saved in your bank account in January earns interest. If you don’t withdraw your savings and the interest, in February you will earn interest on the interest you earned in January. In March, you will earn more interest on the interest you earned in January and February, and so on and so on. This is compound interest.
For a great visual explainer of this, check out this clip from New Zealand television series, ‘Mind Over Money’.*
Why should you care about compound interest?
Saving is hard enough as it is, so you might as well use every advantage you can.
I know, I know, you’ve got bills to pay, trips to plan and cocktails to fund. Though it can be difficult to put that bit extra into a savings account, shares or superannuation, the better off you’ll be in the long term. And yes, I know that’s aaaaaages away.
Unhappily, interest rates in Australia are currently at an all-time low. If you’re planning to put your money into a savings account, make sure to find one that pays the highest rate of interest you can find.
The eighth wonder of the world
A smart guy called Albert Einstein once described compound interest as the eighth wonder of the world, “He who understands it, earns it … he who doesn’t … pays it.”
How do we pay? The slower we repay a debt which charges interest, the more we end up paying back over time.
So, if you have a mortgage, the quicker you can pay it off, the more money you will save in interest.
Find out how much you could save by making small savings sacrifices over time by using ASIC’s compound interest calculator.
*This example shows compound interest calculated at an annual return of 8 percent. At present, most savings accounts are offering 3 percent maximum, but this won’t always be the case.