How To Use Compound Interest To Boost Your Savings

Let’s talk compound interest. It sounds dull and boring and a finance-y term that isn’t worth knowing about, but it’s actually a super easy tool that can help you save big money with minimal effort. And we’re all about that at The Broke Generation, as you know. Albert Einstein even said it was the 8th wonder of the world, so that’s pretty neat.

What is compound interest?

In short, compound interest is interest on your interest. You’re probably familiar with simple interest, which is the interest your money earns in your bank account. Unfortunately for our generation, interest rates have been pretty low for much of our working lives, so we’ve not reaped a whole lot of the rewards yet. 

Compound interest is the interest you earn on the interest you’ve already earned. So say you’ve got $10,000 in a savings account, and each month your bank pays your interest into your account. Right now you’re probably hardly batting an eyelid at that interest because if you’re on, let’s say, 1.8% rate, that’s $180 per year, which means $15 per month.

But, when you consistently leave that $180 a year in your account to earn its own interest, that’s when you start seeing compound interest at work. Of course, it takes a long time for this to bring home the big bucks, but lucky for us, we’re millennials, which means we might not own big properties but we got time to play with. 

How does compound interest work?

Compound interest accumulates over time, and the more money you deposit, the more interest you can earn and therefore the more compound interest you can earn.

Let’s take a look at compound interest at work – assuming you start with $0 in your account.

Here I’ve used a 3% interest rate, which no, isn’t available right now. But historically, interest rates recover and grow again, so over our long periods of time, we’re likely going to see higher rates. To be honest, 3% is incredible conservative for these long periods of time, but I want this to seem as realistic and achievable as possible for you.

Now, the really sweet spot with compound interest is when the total interest earned exceeds the amount you’ve deposited. This tends to require higher interest rates, but like I said, 3% for these calculations is incredibly conservative. 

Here are a couple of examples of that in action. For these I’ve used a 5% interest rate.

How can I save more with compound interest?

The key with compound interest is to firstly, keep saving regularly into a high interest savings account – as high as you can get at the time. Don’t be afraid to switch. Small percentage differences will add up over the long term.

Continuing to save small amounts regularly will allow you to make the most of compound interest because it let’s it do exactly that – compound. 

What about investments?

In times when interest rates are extremely low and sometimes don’t even exceed inflation, investing can be a smart way to enjoy compounding returns on a larger scale.

That said, investments carry risks that saving doesn’t. When you invest in the share market, you’re investing in businesses – which can lose money, and so too can the value of your share. When you save, you’re literally just stashing away your cash and the bank is paying you interest on it. 

Investments benefit from compounding returns in the same way. When you reinvest your returns, you earn returns on those returns – just like the interest example. Plus, long term investing can see you earn average return rates of 8% or more. 

Let’s look at compounding returns in action in an investment setting. Here I’ve used a 6% return rate.

If you’re keen to know more about small, consistent investment amounts, read my Simple Guide to Microinvesting. 

I hope that makes compound interest a whole lot more clear, understandable, and freaking exciting because HELLO big savings, minimal effort, and plenty of spare cash for Aperol spritzs and a box of nuggets on the way home. Boom!

–

PIN FOR LATER