Got a loan or deposit? Compound interest calculator explained

Rainy day funds are essential, and earning interest is a fantastic and easy way to give them a boost. But how do the banks calculate your interest payments? 

Simple: it's compounded!

But in case you're not a mathematician or banking expert, we've broken down how to work out your compound interest payments on your own – which can make comparing high interest savings accounts just that much easier.

(Psst: here's our guide for finding out how much interest you're paying on a home loan).

Whenever you put money away in a bank, the bank will pay you interest (usually each month) in exchange for using your funds in their transactions. The most common type of interest on your deposits is compound interest, which is when the previous month's interest is included in your new balance. That way, you earn interest on your interest, not just your initial balance.

At first it might not seem like it makes a huge difference, but a high interest rate over a number of years can be a great way to keep your savings account looking healthy.

HOT TIP: As a rule of thumb, any savings interest rate over 2% is definitely worth checking out.

Compound interest is a more effective way of earning than simple interest, which only works on your initial deposit.

For example, if you had $25,000 in a savings account earning 4% simple interest p.a., you’d have $30,000 in 5 years.

If you had the same $25,000 in a savings account earning 4% p.a. compounding monthly, you’d have $30,525. That’s $500 more in your pocket, and you didn’t have to lift a finger!

While compound interest is great for your savings account, it’s not so good for loan repayments. For home, personal or car loans, your interest is built into the monthly repayments, so you don’t have to think about it.

With credit card debt it becomes a little trickier. If you’re only making the minimum payments on your credit card balance, you’re not really getting anywhere as far as paying off the principal goes, and interest can compound quickly.

Ready to calculate your compound interest? There are a few things you should know first to make the process a bit easier.

How much have you saved?

You’ll need to know your initial deposit, or the balance of your savings account at present. This is what the amount of interest is based on.

How long will it earn interest?

Are your savings parked for the next five years? Or have you only stashed them away in a high interest savings account for a few months to give them a boost? This can be a little easier to calculate with term deposits, since your money will be locked away for a fixed amount of time.

What is the interest rate?

You’ll need to know your interest rate to work out how much you could earn. This is usual advertised as a standard annual interest rate (look out for the "p.a." after percentages, which stands for "per annum". This will be your yearly interest rate).

Be careful not to mix it up with introductory or bonus rates, which can trick you into thinking your interest payments will be higher or longer lasting than they really rate. But be sure to account for those in your calculations!

How often will the interest be paid?

Interest will usually be calculated daily and be paid monthly or annually. You’ll see the effects of compounding as often as your interest is paid. If your interest compounds monthly, you’ll earn more, because it will be being calculated on a higher balance each month.

Will you make regular deposits?

Got a bonus at work? Or did Aunty Jan send you a cash Christmas present this year? If you find yourself with extra funds – or if you’re a savvy saver and put away part of your pay check every week – and make a deposit into your savings account, that will give you a bigger balance and more interest.

HOT TIP: Some high interest savings accounts will come with monthly minimum deposit requirements in order for you to earn the maximum interest rate, which is usually the standard base rate + bonus interest rate. If this is the case with your account, set up an automatic transfer that sends the right amount into your savings account each month. That way, you won't miss out on any extra earnings.

Here's where our snazzy savings calculator gets to shine! Plug in your values to crunch the numbers, easy peasy.

But if you’re determined to put your maths skills to the test, then here’s how you calculate compound interest:

1. Add 1 to your interest rate (expressed as a decimal).

2. Raise this to the power of 'years' you'll be earning interest for.

3. Multiply the result by the 'principal', which is the current balance of your account.

4. Complete the order of operations, then voila! This will be your new balance.

Here’s an example: If you put $10,000 away in a savings account to earn 3% p.a. for 2 years, the calculations to work out your compound interest might look like this:

And you could see that your compounded interest would be $609 for the two year term.

But what if you're only depositing for a few short months? If you're comparing quick term deposits or just needing a quick savings boosts, here's how to calculate your monthly compound interest.

1. Divide your interest rate by 12 (interest rates are expressed annually, so to get a monthly figure, you have to divide it by the number of months in a year).

2. Add 1 to this to account for the effects of compounding.

3. Raise to the power of the number of months you're storing your money.

4. Multiply it all by the 'principal', which is the current balance of your account.

5. Ta-da! Here's your new balance with monthly interest.

A little confused? Let's go back to our example: If you took $10,000 at 3% p.a., and put it away for the same two years, but with interest compounding monthly, you’d calculate the interest like this:

And if you look at the example above, you can see that by compounding monthly, you’ve made an extra $8.57.

How accurate is this?

We like numbers here at Mozo, but we’re not computers. While this formula is tried and true for working out compound interest, you could find your calculations come out a few cents (or maybe even a dollar or two) off the exact amount, because of things like rounding and good old fashioned human error.

When we put the above example through our savings calculator, which is a computer, it calculated the new balance as $10,618. That's pretty dang close!

Ready to store your money? Compare high interest savings accounts below.