When you invest money, you earn interest on it. When you earn compound interest, the previous year’s interest is included in your balance, so you earn interest on the new total. Essentially, this means that you earn interest on your interest.
You invest R5,000 at 10% interest
10% of R5,000 = R500 interest
Now you have R5,000 + R500 interest = R5,500 invested
10% of R5,500 = R550 interest
Now you have R5,500 + R550 = R6,050 invested
10% of R6,050 = R605 interest
So, at the end of 3 years you have R6,655.
The compound interest doesn’t look like much, but it adds up in the long term. It also helps if you keep adding to your investment each month. This is why it’s so important to start any investment, including saving for retirement, as early on as possible.
The bad news
While compound interest is great for your savings and investment accounts, it’s not so good for you when it comes to paying your credit card. Every month you’re charged compound interest on the whole amount you owe – what you’ve spent plus the interest. So if you only make the minimum monthly payments on your credit card balance, the interest keeps compounding each month, adding even more to your outstanding balance and pushing you further into debt.
Paying the full amount owing on your credit card each month avoids this entirely, because then you don’t get charged interest.
Making the most of compound interest
Compounding interest can give your savings and investments a big boost, but it can also make repaying debt more difficult. Whether you are investing or borrowing money, understanding how compounding works can help you to make smarter choices and save more money in the long run.