The negative side of inflation is hard to miss. The rising cost of living makes for many dramatic headlines – ones that get plenty of attention, too. But did you know there is a way inflation can work in your favour? First up, let’s look at a basic definition of compound interest:
What is compound interest?
“Thought to have originated in 17th century Italy, compound interest can be thought of as earning interest on interest, and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.”
How to calculate compound interest
To help explain this financial wonder, the easiest way is to take a look at a couple of examples.
Let’s say you have a deposit of $10,000 invested at a compounding interest rate of 6%. If you left this $10,000 in a savings account, after 24 years you would have $40,0000!
Government financial information website Sorted explains one way of calculating compound interest, known as the Rule of 72: if you divide your compound interest rate by 72, the result will be the number of years it will take for your money to double.
So, in our example above, we would divide 72 by 6 (because we used an example of 6% interest), to find that it would take 12 years (72 ÷ 6) to reach $20,000 (our initial investment of $10,000 doubled).
Don’t fancy doing the maths yourself? You’re in luck, as there are many compounding interest calculators available, including on the Sorted website.
To be completely accurate, you need to reduce the interest rate to allow for inflation. For example, if we allow for 2% inflation, the interest rate used above should be 4%.
How does compounding interest compare to simple interest?
What if you had $10,000 and you received the 6% interest at the end of the 24 years ie, you weren’t earning interest on top of your interest? In this scenario, you would only land up $600 richer – more than $39,000 less than in the scenario above! Inflation doesn’t seem so evil now, does it?
Even if you have a much smaller amount than $10,000 to invest, you’re still much better off putting your money in an account where you can make the most of compound interest than you are shoving it under a mattress.
Can you earn compound interest on your KiwiSaver?
The answer to whether you earn compound interest on your KiwiSaver depends a bit on how much you want to split hairs. Technically, you are earning returns, not interest, on KiwiSaver. So, if you want to get technical, you could say you make “compound returns” on your KiwiSaver. But, ultimately, the compound interest savings principle still applies. Your investment fund may fluctuate over time, but, regardless, your investment will still grow on top of the amount you have made through your investment, ie, not just growing on that amount you initially put into your KiwiSaver.
Joining KiwiSaver is a key investment strategy to support retirement savings or your first home deposit. So is making sure you have chosen a KiwiSaver scheme and account that works for you. To help you weigh up your options, Canstar compares providers and products in the market.
Ultimately, inflation is unavoidable, so why not try to use it to your advantage? If you’ve set yourself a goal to boost your savings this year, this could be your way to do it.
But, don’t forget, as great as compound interest is for savings, it can have a seriously scary effect on debt if you’re not careful, for example compound interest on a negative credit card balance. If you’re having trouble keeping on top of your credit card debt, check out our guide on debt-busting strategies. And if your choice of credit card is working against you rather than for you, it might be time to review your credit card options.
Shop around and look for an investment that has a risk level you are comfortable with. While the savings rate environment is not so crash hot right now, doing something is always better than doing nothing. To help you in your decision process, use Canstar’s suite of free financial comparison tools. Canstar compares savings accounts, term deposits and KiwiSaver funds, among others, to help you with those tricky financial choices.