What The Heck Is Compound Interest, And How Does It Affect You?

Look, yes. I can already tell your eyes have glazed over. Compound interest is fundamentally not the most interesting of topics. But perhaps this quote from none other than Albert Einstein will convince you that it’s worth paying attention to:

Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.

Every time you put money in your bank, take out a loan or use a credit card, you’ve gotta have the difference between simple and compound interest at the forefront of your mind. It can be the difference between a loan that’s real easy to pay off, and one which will give you some serious dramas down the track.

So what is it? Put most simply, compound interest is interest on interest. We promise it’s less complex than it sounds. Let’s say you invested $100 into a bank account with 2% interest per annum, then you’d have $102 at the end of the year. Go you! If you do nothing, at the end of the next year the 2% will be calculated on the $102 instead, and so on. It keeps on growing.

That’s all well and good when we’re talking about putting money in the bank – that’s the kind of investment you don’t really have to worry about. Where compound interest really becomes something you need to think about is where it applies to debt. That’s when it can start working against you.

Let’s say you take out a loan of $1000. If its simple interest on the loan – let’s say calculated at 20% every year for a term of 5 years – that means you’d have to pay $2000 at the end of it – no ifs, ands or buts. (That’s a terrible loan, by the way, but I’m just trying to keep things simple for you.)

With compound interest, it’s not quite as simple. The interest accrues based on to total payable amount including previously accrued interest, not just the principal amount of the loan. What does that mean in practice? It means that if you’re not paying your minimum repayments or above, you could end up forking out a lot more than you would have otherwise.

“It can work really well with you, if you are saving,” says Lynne Sutherland, the Executive General Manager Stores & Specialty Banking at Suncorp. But if you’re in debt, then it can work against you.”

“The best thing to try to do is to try and pay back any outstanding debt you got, either as fast as possible, or in the case of credit cards, just pay off the outstanding balance every month.”

It definitely pays to do your research. A loan using compound interest might seem like its cheaper than another loan using simple interest, but it’s worth thinking a simple question: is it possible that I might get caught out and be unable to make my repayments? Is the answer is yes, you could end up paying a lot more.

It’s also important to not only keep an eye on whether a loan uses simple or compound interest, but how often the interest is compounded. It could be annually, monthly, or even weekly. “You really do need to look at the fine print when you’re setting up a loan,” Sutherland says.

“You need to look at what is the percentage interest rate that you’re being charged, and over what period. They’re typically quoted in per-annum terms. But sometimes, they can be per month.”

Sutherland told PEDESTRIAN.TV that research is absolutely key:

I think what we would advise people in general is to do their research, compare. There’s some good sites that help people do comparisons of interest rate charges and costs. And have a look at what might suit them the best. Cheapest doesn’t always necessarily mean the best. But if someone was very price sensitive, or concerned about that, then there’s plenty of tools that can help them calculate that.

So that’s the long and short of it – do your research, and keep this key point in mind: a loan might look cheaper, but you’ve gotta read the fine print.