Spent a lot lately? Save more with compound interest

People who know about saving money swear by compound interest. They love to call it the 'power' of compound interest. 

But it's not an instant power, more of a slow burn. Simply, the longer you park your money in a good savings account, the more interest you earn on top of that initial deposit. This is why ASIC’s Moneysmart advises savers to start as soon as they can to start building their money up - smart saving is about acting now in preparation for the future. 

Let's take a look at how compound interest works then. 

How to save money, smartly 

The idea with compound interest is that you earn interest on interest. For example, let's say you started with $1,000 in your savings account and added $200 per month over 5 years at 5% p.a. interest. After just 20 months, your balance would have jumped to $5,249. 

This can be broken down as follows: $1,000 initial deposit + $4,000 ($200 x 20 months) + $249 interest = $5,249.

After 5 years or 60 months, the breakdown would be as follows: $1,000 +  $12,000 ($200 x 60) + $1,885 interest = $14,885. 

You can see that by waiting for the interest to be applied each month for many months, your initial money can truly grow to something substantial! (Try these sums yourself on our savings calculator).

Looking for a better savings rate

Now just for kicks, imagine you found a slightly better interest rate, such as the AMP Saver Account which is currently at 5.20% (if conditions are met) or the ME HomeME Savings Account which offers 5.55% (if conditions are met). The compound interest with even a slightly higher rate is noticeably better. 

Let's make it 5.50%, for our example: 

That initial $1,000 would grow to $15,092, if you were to deposit $200 each month over 5 years. The amount of interest earned over this period would be $2,092!

This is why people refer to it as a power - the result of incremental increases can be stunning. Remember, this is unlike simple interest, which is calculated based on your principal amount only. Instead, compound interest calculates the interest on your principal amount plus the interest paid each month. As mentioned, it’s interest on interest!

This is why it's best to stash your money now and leave it for a while, so that the compounding effect can take hold. If you do this, you perpetually increase the interest you earn (provided you’re applying the same interest rate or better). 

And finally, it’s worth noting that interest is usually calculated on your balance daily then paid into your account each month.

Right now, with some savings account research, you can still find some rates at 5% or higher, which isn't too bad in the context of the last 10 years. It’s worth comparing a few different savings accounts, and you can start by checking out some of the top savers below.