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Compound interest and your savings account
Compound interest means you earn interest on your interest, so your money grows over time. Here's how to benefit from a savings account with compound interest.
What is compound interest?
Compound interest means you to earn interest on your interest over and over again, so your money continues to grow even if you're not adding to it. It is different to simple interest, which is only calculated on the initial balance.
Compound interest savings accounts
One of the main ways to earn compound interest is with a savings account. These accounts usually calculate your interest daily and pay interest monthly, so the following month you can earn interest on the interest you've just earned. This is why they're such a popular option for growing your money.
Here are some savings accounts that pay compound interest.
How does compound interest work?
The best way to explain how compound interest works is with an example.
- Let's say you invest $1,000 in an account with an interest rate of 5% p.a. compounded for 5 years.
- The initial investment of $1,000 earns $50 in the first year, giving you a total of $1,050.
- The following year, you still earn the same rate of 5% p.a. – but this time it's applied to $1,050, not $1,000.
- This will make your balance $1,102.50 after the second year, even though you haven't deposited any extra money into the account yourself.
- This amount ($1,102.50) is the base for compounding for the third year, and so on. After 5 years, you'll have $1,283.
- If your money was in an account earning simple interest, you would earn returns based on the initial $1,000 only (an amount of $50 per year, every year). After 5 years, you'd have $1,250.
The longer your timeline ahead of you, the more your balance grows. In our fictional example, after 10 years, you'd have $1,647. After 20 years, $2,713. And after 50 years, $12,119 – without ever adding an extra cent of your own money.
To get the most benefit out of compound interest, deposit as much as you can into your account and restrict the number of withdrawals you make. The more money that is in your account at the end of the month, the more interest you will earn.
Use our calculator to see how you can benefit from compound interest
How can compound interest help you grow your savings?
Compound interest can turn a small amount of money today into a large amount of money over the space of 10, 20 or 30 years.
The longer your timeline ahead of you, the more you stand to benefit from compound interest. For example, if you are 22 years old and set some savings aside for retirement at age 65, you have 43 years of compound growth in your future.
How do banks calculate compound interest?
Interest is typically calculated on a daily basis on the daily closing balance. Here's the savings account equation:
Daily closing balance x interest rate (as a percentage) / 365
Interest begins to accumulate on the day the opening deposit is made in your savings account. It's then usually credited into your account on the last day of each month. If you choose to close your account, your accrued interest will be deposited on the day it's closed.
Any interest awarded to your savings account is usually available for use on the same day it's been credited. The daily closing balance of your savings account tends to include all cleared and uncleared transactions. This may be because electronic transfers to your linked bank account usually occur on a business day.
How do you find the monthly interest rate?
The monthly variable interest rate will be clearly displayed on the provider's website under the product description for the particular account you’re looking at. Instead of going to each bank's website, you can take a look at the latest high interest savings account interest rates in our guide. It is important to remember that the interest rate is variable, meaning it will change from time to time.
What are the pros and cons of compound interest?
- Easy access to your money. The majority of Australian savings accounts that provide compound interest allow you to make withdrawals and additional deposits whenever you need to.
- Lower balance requirements. Many accounts that offer compound interest do so with a low minimum balance requirement.
- Bonus rates. You can find savings accounts with compound interest that do give you an incentive of bonus interest for not making any withdrawals in a month.
- Increased interest income. With compound interest, your earnings are being increased exponentially, as each month the interest is being calculated on a slightly higher balance.
- Lower rates. The annual rates are usually not as high as accounts like term deposits, where your money is locked into an account for a set period.
- Accessibility. For some Australians, having open access to your savings isn't ideal, as you can easily dip into it for daily needs, causing you to lose a portion of your interest earnings.
- Timeline. To really get the benefits of compounding, you want to be in it for the long haul. You may get better returns on your money in other ways if you have a shorter timeline to work with.
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