We're going to talk about interest, starting with the normal boring kind, then the compounding kind. Most people encounter interest in two ways - banks will pay you for leaving your money in an account. They will also charge you interest on loans.

For example, my bank pays me 3.05% per year. This is calculated daily and paid monthly. So every day I leave $1,000 in the account, they owe me 8cents ($1,000 x 3.05% = $30.50 a year. Divided by 365 = 8cents a day). Once a month they add up what they owe me and deposit into my account (roughly $2.55).

Inversely, my home loan runs at 4.14% p/a. So for every $1,000 I have borrowed, I pay the bank 11cents a day, or $3.46 per month. This is how banks make money, that $1,000 you have sitting in a savings account isn't in a vault somewhere guarded by dragons and goblins. The bank has given it to someone else - they pay you 8cents a day, charge the other guy 11cents and gleefully collect that 3cents for themselves. They aren't doing it in tiny $1,000 amounts, they're working in billions and trillions.

So obviously you win by taking that $1,000 that you have in savings and paying down what you owe on the loan. But when it's only $0.91 a month difference it's easy to see why you wouldn't. It doesn't cost you

*that*much. But on a 30-year, $300,000 loan you end up paying almost $225,000 in interest.

If you're able to find a little extra money and push it into your mortgage, then you can bring those numbers down. (Related post: 3 ways to shorten your mortgage right now)

Okay, that's the unpleasant part about mortgages and costing you money. Let's look at the fun part of Compound Interest working for you.

Compound interest is more fun than regular interest. In the above scenario you only make $2.55 a month from your $1,000 savings. Which isn't even enough for a coffee.When you look at it over time, you probably imagine this graph.

Let's face it that graph isn't very inspiring. If you leave your money alone in a 'high interest' account for 10 years, you get less than $300. Woop de doo. Except that isn't 100% correct.

If you were to withdraw the $2.55 you were paid every month, this is exactly what would happen. But if you leave the $2.55 in the account, it also earns interest, a whole 0.6 cents in a month. Then next month you earn $2.55 point oh six cents. It's only a little tiny bit more, but each month it's a little tiny bit more than the last month. When you include compound interest you get a graph that looks like this.

Admittedly these are tiny numbers. You can make it more exciting by moving the decimal point to the right, and working with $10,000 and $23.70 per month, but I thought having $1,000 in savings was a more realistic starting point.

I think most people miss out on compound interest, because we save small amounts of money for a short time. In the grand scheme of things, even saving for a house is a small amount in a short time, say $60k in 4 years. Starting from zero you need to save $1,250 per month. If you consider compound interest you need to save $1,174 per month, and you'll get $3,653 of free money from interest.

You're still doing the heavy lifting yourself and for many people buying a house will be their biggest purchase. For other savings goals like travel or a new car compound interest doesn't play in because the saving time is much shorter.

However, if you are saving for retirement or financial independence then compound interest becomes your best friend. Putting aside $100 a week for one year equals $5,200 + $73 interest. Over 25 years $100 a week becomes $130,000 + $64,626 interest. Again, the graph is a curve. And all this is assuming a measly 3.05% return in a high interest bank account like ING Direct (currently offering $100 sign up bonus with the code

**EBB062**).

To really kick off your investments, have a look at RateSetter (returns over 8% with Peer-to-Peer lending) or Acorns (my personal returns are nearing 10%, long term I expect more like 7%)

If you made it this far, go play with the MoneySmart calculators, particularly the Savings Calculator and Compound Interest Calculator. Using these calculators I can see that at the 16 year mark and 8% investment like RateSetter will have earned more through interest that your have contributed. That is the power of compound interest.

(Related post: Where's my million? - includes a fancy calculator)

*Boring disclaimer: If you sign up for ING I also get $100 for introducing you. They are a*

**fantastic**bank and I have never been charged a single fee. They also cover the cost of ATM withdrawals, and give you a little money back if you take out more than $200 cash during an EFTPOS transaction. I highly recommend them, not just because they are offering me a little cash as well.
It'd be awesome if you could put together a simple guide for Vanguard funds too. People often look at the returns and get confused between dividends, market shift and reinvestment.

ReplyDeleteGreat suggestion - I've been trying to work on one but Vanguards site is much less friendly than Acorns or RateSetter so getting the detailed information is tricky.

DeleteIt's definitely in the pipeline, but as you said understanding dividends and reinvestment, and buying direct through Vanguard or buying their ETFs through a broker can all get super confusing.

Plus one for a request on simple guide for Vanguard! I'm already across Ratesetter and Acorns and currently gearing myself up to get into the dividend market and shares.

ReplyDeleteOh dear! Pressure it on now! :)

DeleteWill you accept a two-parter? Purchasing the ETFs through a third-party broker is far easier to explain than direct through the Vanguard platform :) Two posts for clarity

Sounds good! I want to buy direct through Vanguard but I think brokerage could be more useful for a wider audience?

ReplyDeleteI'm still of two minds about Acorns. I'm pretty good at saving as is, and the fees are a tad high. You did a great job of explaining it though.

Thanks - once you have over $1,500 with Acorns the fees aren't too bad (0.25%) but since their market is investing from nothing without noticing, it takes a long time to hit that threshold.

DeleteMaybe I'll just dump the $5000 I've set aside for my next investment purchase in Acorns, and hold off on Vanguard for your explanation!!

ReplyDeletehmm, just saw a typo in my last comment - the fees only drop to 0.25% p/a when you have $5,000 in the account (I accidentally wrote $1,500)

DeleteRe: Acorns or Vanguard - For that $5k Acorns would charge 0.25%p/a, where Vanguard would charge 0.75%pa if you bought their Australian Shares Fund.

However Acorns is actually investing into Vanguard funds, I suspect (but can't confirm) that you will actually be paying the Vanguard fees, and then paying the Acorns fees afterward.

Vanguard fees happen reasonably invisibly (they show up on statements as slight reductions in dividend payments) whereas Acorns pulls their fees directly from your bank account.

This comment almost turned into a review itself!

I made the leap to Vanguard today, International Shares. Perhaps Acorns for the next $5000 I save to add a bit more diversity again. I'm aiming to have seed funds of $10000 in RateSetter, Vanguard and Acorns eventually I think.

DeleteExcellent stuff! Congratulations! Now comes the hard part of not checking on your stocks every day, haha. Remember it's a long term game - things are volatile with Trump, but long term everything will track upwards

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