How does money make money while it’s just sitting there? This article is part of our new series Finance Explained, sponsored by BNZ.

You may have heard of the term “compound interest” and how it can make you money.

But how does it work?

Compound interest explained

Finance expert and savings product manager at BNZ Liv Coleman says to understand compound interest, it’s best to understand what interest is first.

“Interest is money that a bank or other financial institution pays you for parking your cash in a savings account.

“So for the pleasure of having your money, they give you a little bit back.”

Compound interest, Liv says, is the “magical” thing that happens when you start earning interest on that interest.

So you’re earning interest from the money you’ve saved, and you're earning interest on that interest itself.

How does this make my money grow?

The key ingredient is time, Liv says.

“Maybe at the start it's not earning a huge amount of compound interest because you just started saving. But over time, it can really start to add up as it continues to grow exponentially.”

For example, if you put $100 into a savings account that earns 4% interest each year, you’ll have $104 at the end of the first year.

You’ll have $108.16 after the second year.

$112.49 after the third year.

And $148.02 after the tenth year.

Your initial contribution was $100, and you’ve earnt an additional $48.02 in interest on top of that.

Compound interest becomes even more powerful if you make regular contributions rather than just a one-off contribution at the start.

Liv provides an example where if you put away $100 a month over ten years into an account with a 4% return, you’ll have $14,923.15.

$2823.15 of that would be interest you’ve earnt – keeping in mind these figures don’t take into account tax, which will impact the amount of interest you earn.

If you keep chugging away and saving $100 a month over 30 years into that account, you’d have $69,967.64.

$33,867.64 of that would be interest.

As time goes on, Liv says you eventually reach a tipping point where the interest you’ve earnt is actually greater than the amount you’ve contributed.

Where can I earn compound interest?

There are a range of different savings accounts where you can earn interest, with different conditions and benefits, Liv says.

There are standard savings accounts where you deposit your money and get paid interest on every dollar.

There are accounts where you get paid bonus interest if you continue to make contributions.

There are also term deposits where you can lock your money away for a set period of time and potentially a higher interest rate.

These are all factors to consider when you’re shopping around for where to put your savings.

To help your research, Liv says that online calculators such as these ones from Sorted and Money Hub are useful tools to visualise how much interest you could earn based on your contributions and the interest rate.

I’m in. Where do I begin?

Liv says the first thing to do is check with your bank and see if you already have a savings account set up.

If not, you can usually open a savings account from your bank’s app.

Liv also emphasises that no amount is too small to start earning compound interest.

If you’re saving for a goal in a transactional account that earns no interest then you’re missing out. If you pop it into a savings account that pays interest on every dollar, then your money is working for you.

You’re still earning a little something, yet can withdraw the money if you really need to.

“Time can be a really critical factor, but it's not the only factor,” Liv says.

So it’s never too late to start.

“Even if you feel like you only have a little bit, just starting now and continuing is the best way to do this.”

This article contains general information only, not professional advice. BNZ is not liable for any losses resulting from this article. 

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