Spend you dollars, on more dollars!

Let's do some maths, baby! I'm going to talk about money, using your money to 'buy' more money, and investing. Plus I get to play with charts and graphs.

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.

So you come out $40 further ahead than you thought you would be. Doesn't sound like much, but with compound interest you have 3% more in ten years. Again, not a huge number, but it's free money. Then if you look at it over a longer period you also get this...

There are a few things about this chart that give me a nerdy little thrill. One is that in 30 years, you can get $1,343 of free money with compound interest, more than double what you put aside. Compounding gets you 26% more than if you withdrew your money every month. And that red line isn't straight, it's curving. Every month you don't touch that money, the amount of interest you are paid goes up. In the first month you were making $2.55. By the 30 year mark you are making $5.60 a month. And each month this amount is increasing a noticeable amount, $5.62 at 30 years and one month, then $5.63, then $5.64.

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.