The Cost of Compound Interest

Compound interest is essentially earning or being charged interest on an initial amount (often referred to as the principal amount) plus any interest earned or accrued. Don’t have a clue what we’re on about? No dramas. Let’s run through a quick example to help clear things up a bit.

So, say you invest $1,000 into an investment fund that earns 5% interest every month. In month one, you’d earn $50 and your total would be $1,050.

In month two however, instead of earning another $50, you’d be taking 5% of $1,050 which is $52.50. This would make your total $1,102.50. Then in month three, you’d take 5% of $1,102.50 which is about $55.13, giving you $1,157.63. 

The key thing to note here is that if each month you’d earned 5% on just the $1,000 you’d originally put in, you’d have $1,150. But, as the interest you’ve earned has been added to the $1,000 on a monthly basis, you’ve been earning interest on your interest - and it’s given you an additional $7.63. This is compound interest at work - the multiplying effect of earning interest on a greater sum each month. 

Got it? Sweet.

Compound interest is a double-edged sword. If you’re saving or investing, it can help you grow your money quicker, which is great. It also means that the earlier you start putting money aside, the greater your earning potential. 

However, with borrowing money, it means that debts can quickly build up if they’re not being repaid. For instance, if you’re borrowing on a credit card and only making the minimum monthly repayment, the effect of compound interest will mean that the outstanding debt builds up quickly. For example, if you had a credit card with an interest rate of 20% p.a. and a balance of $10,000, then only made the minimum repayment of 3% per month, you’d incur $965 in interest in just 6 months. And that’s without making any additional purchases!

By now you’ve probably worked out that if you already have debt and you’re not chipping away at it, it’s building up quicker the longer you leave it. Plus, there’s also the stress and anxiety that comes with having unchecked debt. That’s why it’s so important you don’t ignore the problem. 

All sounding a bit too familiar? Then the most important thing is to take action as soon as possible. At Wisr we’ve developed Debt Bustr - an easy-to-follow 5 step approach to help Aussies tackle their debts. 

The first step is to bring all your debts together by adding them into the Debt Bustr calculator. This will tell you the total cost of your debts, including compound interest, so you have a much clearer picture of how much you owe.

You can then use our Debt Bustr calculator to see if you can save money and get debt free sooner by consolidating with a Wisr Debt Consolidation loan. From here, it’s down to you to choose the best course of action for you and your finances. You can either get a free consolidation estimate that won’t impact your credit score, or you can choose another debt repayment method. Whichever you decide, remember the most important thing is to take action and stop your debt building.