What Is Compound Interest?
Compound interest is interest calculated on both your original principal and the interest you've already earned. Unlike simple interest — which only ever applies to your starting amount — compound interest lets your money grow exponentially over time. Albert Einstein allegedly called it "the eighth wonder of the world," and while that quote is probably apocryphal, the math behind it is genuinely remarkable.
The key difference is reinvestment. With simple interest on $10,000 at 7% annually, you earn $700 every year, no matter how long you hold the investment. With compound interest, your first year earns $700 — but the second year you're earning 7% on $10,700, so you earn $749. By year 20, you're earning over $2,400 in interest on that same original $10,000, even without adding a cent.
How the Compound Interest Formula Works
The standard formula for compound interest without regular contributions is:
A = P × (1 + r/n)nt
Where:
- A = final amount
- P = principal (starting amount)
- r = annual interest rate (as a decimal)
- n = number of times interest compounds per year
- t = number of years
When you add regular contributions (which most people do), the calculation becomes more complex. Our calculator handles this automatically, adding each monthly contribution at the correct point in the compounding cycle.
Compounding Frequency: Does It Matter?
Yes — though perhaps less than you'd think. More frequent compounding produces a slightly higher return because you're earning interest on your interest sooner. Here's what $10,000 at 7% for 20 years looks like under different frequencies:
- Annual: $38,697
- Quarterly: $39,716
- Monthly: $40,000 (approx)
- Daily: $40,139
The difference between annual and daily compounding is about $1,400 over 20 years — real but not dramatic. What matters far more is the rate of return and how long you stay invested.
Worked Example 1: Starting a Share Portfolio
Priya is 30 years old and invests $15,000 into a diversified index fund that has returned an average of 8% per year historically. She also commits to adding $300 per month. Here's how that looks at retirement age 65:
- Total contributions: $15,000 + (35 years × 12 months × $300) = $141,000
- Final balance: approximately $672,000
- Interest earned: approximately $531,000
The interest earned is nearly four times the amount Priya personally contributed. That's the compounding effect over 35 years.
Worked Example 2: High-Interest Savings Account
Marcus puts $5,000 in a high-interest savings account paying 4.8% p.a., compounding monthly. He contributes nothing extra. After 10 years:
- Starting amount: $5,000
- Interest rate: 4.8% monthly compounding
- Final balance: approximately $8,047
- Interest earned: $3,047 (a 61% gain)
A savings account won't make you rich, but compound interest over a decade produces meaningful results — especially if inflation is lower than your rate.
The Rule of 72
A handy mental shortcut: divide 72 by your annual interest rate to estimate how long it takes to double your money. At 7%, your money doubles roughly every 10.3 years (72 ÷ 7 = 10.3). At 10%, it doubles every 7.2 years. This isn't perfectly precise but it's accurate enough for planning purposes and a good sanity check when reviewing investment projections.
Compound Interest vs. Superannuation
Australians have a built-in compound interest machine in their superannuation funds. The compulsory Superannuation Guarantee (currently 11.5%) means your employer is automatically contributing to a long-term compounding investment on your behalf. Super returns — typically 7–9% over long periods in a balanced fund — combined with decades of compounding explain why even modest earners can retire with substantial balances. Check our Superannuation Calculator for a personalised projection.
Inflation and Real Returns
One number our calculator handles is the inflation adjustment. A nominal return of 7% sounds great — but if inflation is running at 3%, your real purchasing power grows at roughly 4%. This matters enormously for long-term planning. A balance of $600,000 in 30 years may feel significant now, but in real terms (today's dollars), it might be closer to $250,000 in purchasing power. Always plan in real returns, not nominal ones.
Australian Context: Where to Find Good Returns
In Australia, compound interest applies to several common products:
- High-interest savings accounts: Currently 4.5–5.3% p.a. with major banks and neobanks
- Term deposits: 4.5–5.1% p.a. for 12-month terms (as at 2024–25)
- Index funds (ETFs): Historical average 7–10% p.a. long-term (not guaranteed)
- Managed funds: Variable; fees reduce effective return significantly
- Superannuation: 7–9% p.a. over long periods in a balanced fund
For serious wealth building, the share market has historically outperformed all fixed-income options over 10+ year periods. But it also carries risk of short-term losses, so your timeline and risk tolerance matter.
Starting Early vs. Starting Late
The single most powerful input to compound interest is time. Compare two investors, both earning 7%:
- Sophie starts at 22, invests $200/month for 43 years → final balance ~$680,000
- Jake starts at 42, invests $200/month for 23 years → final balance ~$132,000
Jake contributes the same monthly amount, and both invest for more than two decades — but Sophie ends up with over five times as much. The extra 20 years Sophie has aren't just additive; they're multiplicative. This is why financial advisers relentlessly push young Australians to start investing early, even with small amounts.
5 FAQs About Compound Interest
Yes. Interest earned in savings accounts is taxed as ordinary income at your marginal tax rate. Investment returns in shares (capital gains and dividends) are taxed differently — long-term capital gains held 12+ months receive a 50% CGT discount. Returns inside super are taxed at a maximum of 15% during accumulation, which is why super is such a tax-effective vehicle for long-term compounding.
Most Australian savings accounts calculate interest daily but credit it monthly. This means you're effectively getting daily compounding credited once a month, which is excellent. Always check the product disclosure statement — some older accounts still compound quarterly or annually.
Compound interest technically refers to fixed-rate products like savings accounts. Compound returns is the broader term used for variable assets like shares or property, where the "interest" equivalent is capital growth plus dividends. The maths work the same way, but the actual return varies year to year unlike a fixed interest rate.
Yes — and this is important. Compound interest on debts (credit cards, personal loans) works against you. A credit card balance left unpaid at 20% p.a. compounding monthly will grow very quickly. This is why paying off high-interest debt should always come before focusing on investment returns — you're unlikely to reliably earn 20% on investments.
For conservative planning: 5–6% for a balanced super or managed fund. For growth-oriented investments (e.g. shares/ETFs): 7–9% historical average. For high-interest savings: 4–5% at current rates. For inflation adjustment, the RBA targets 2–3% p.a. Always use after-fee returns — management fees can easily reduce your effective return by 0.5–1.5% per year.