What is... | January 18, 2012

What is compound interest?

According to urban legend, Albert Einstein referred to compound interest as the most powerful force in the universe. Whether he truly said that or not, savers and borrowers should understand compound interest.

Just under half of more than 1,200 respondents in an eZonomics poll knew how compound interest works.

Pay interest on my interest
Compound interest is a key way to grow savings and investments. It works when interest is paid on interest. This leads to exponential growth over time. In more detail, interest compounds when money invested earns interest and then – when the original sum and the original interest are unspent – interest in the next period is paid on both. Over many years, the pattern is repeated, growing the original investment at an increasingly rapid rate.

But beware, compound interest on debt works in a similar way, growing the debt if interest is left to compound.

The immediate lesson for savers is the sooner you start the more you will accumulate. For borrowers, the sooner and more quickly you start to pay off debt, the less will be paid in total. However, these immediate lessons hide four important issues – the interest rate earned (or charged), the frequency at which interest is paid (or charged), the need to re-invest and the perils of procrastination.

Interest pays
Higher interest rates mean money saved (or owed) grows more quickly. For example, over five years, €1000 reinvested at 3% each year will grow to €1159. At 5%, this increases to €1276 and at 10% to €1610. Website Maths is Fun lists formula behind the calculations.

Small changes in the interest earned (or charged) can add up to large differences over time. But be careful to scrutinise figures to avoid falling for thinking traps – such as the left hand digit bias – and remember that contract terms (such as penalties for withdrawing early) and service level can also be important.

Frequency pays
It can pay off financially for savers to get interest paid daily or monthly rather than annually as compounding starts earlier. Agreements may offer lower interest rates for monthly rather than annual interest payouts – so do the maths. Still, a lower interest rate paid more frequently may pay more than a higher interest rate paid less often. Earning 1% a month compounding is a better deal than 12% a year.

Watch out for this if buying goods on payment plans, as advertised small monthly charges can add up over time. Economist Tim Harford highlights research showing 93% of people in a United States study chose a more expensive repayment plan partly because they misunderstood the implications of compound interest rates on loans.

Reinvestment pays
Savers must not take interest earned away from their original investment if they want interest to compound. Earning interest on past interest is essential. Keeping interest earned with the original investment is known as reinvestment.

In the eZonomics video I can’t possibly save that much, ING senior economist Ian Bright tells how reinvestment is important for reaching long term saving goals.

For similar reasons, it is important for borrowers to keep up with agreed payment schedules (and to pay more than the minimum amount on credit cards) to prevent outstanding loans from rapidly rising.

Procrastination doesn’t pay
Although the benefits of starting to save or pay off debt sooner rather than later are well known and publicised, people often put it off. In fact, as the Cost of procrastination video says, a UK Financial Services Authority study identified procrastination as one of the main factors affecting the amount people saved.

ING eZonomics offers tips to cut procrastination. There are informal approaches (such as using reminders and making deals with friends) and more formal approaches (such as companies asking workers to commit in advance to saving for pensions). With compound interest, cutting procrastination now could really pay off in the future.


eZonomics team
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