Interest plays a big role in your savings and debt. It determines how much you’ll receive for keeping your money in the bank and it also determines how much you’re going to pay your creditors. But what power does compound interest have on your finances?
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What is compound interest?
According to Ester Ochse, head of product at FNB Money Management, compound interest means that you’re earning interest on interest. The interest is calculated on the capital amount together with the interest earned on that amount over the period of your loan and deposits. It’s different from simple interest where you only earn interest on the capital amount.
Thami Cele, head of savings and investments at Absa Retail and Business Banking, explains:
If you earn simple interest, your annual interest will be calculated based on the initial savings amount or capital (R100) every year. Thus, you will earn R10 in interest each year.
Year 1: R100 x 10% = R10 in interest
Year 2: R100 x 10% = R10 in interest
Total interest earned after 2 years = R20
If you earn compound interest, your annual interest will be based on the initial savings amount or capital (R100) plus all the interest earned up to that point. In other words, you will earn interest on the capital (R100) as well as the interest.
Year 1: R100 x 10% = R10 in interest
Year 2: (R100 + R10) x 10% = R11 in interest
Total interest after 2 years = R21
READ MORE: Which savings accounts offer the best interest rates?
How does it affect your savings and loans?
Compound interest is often referred to as the eighth wonder of the world, says Cele.
Over time, particularly long periods of time, earning interest on your capital as well as your interest, adds up. It can make a significant difference to your savings, he says.
Ochse says compound interest has a great effect because the interest earns interest - as explained in the example above.
“The true magic of interest happens over a longer period when the exponential effect comes into play,” she says.
On the loan side you’ll have the reverse of paying interest on interest. The quicker you pay off your debt, the more you save on interest.
For example, if you miss your payments your debt will accrue compound interest. That means you’ll pay interest on the capital balance and outstanding interest that is already accrued. Therefore, you’ll pay more than you would have if you hadn’t missed your payments.
Cele says allowing your interest on debt to compound has dire consequences if you’re over-indebted. This is because interest gets capitalised (becomes part of the capital).
Compound Interest has the power to make you the master of your destiny if applied correctly, especially when saving money. However, it’s never a good idea to let the interest on your debt compound. That could leave you trapped in the cycle of debt.
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