Compound interest means that you earn interest on both the money you’ve saved and the interest you’ve earned. This article is part of our Tots To Teens and Simplicity partnership to help families tackle the increasing cost of living.

For example, imagine you invest $1,000 (your principal) and it earns 5% (the interest rate) a year. After the first year, you have $1,050 – your original principal, plus 5% ($50). The second year though, you earn $52.50 in interest, because now the interest is 5% of $1,050 (of your principal $1000 and of your interest $50 already earned). This repeats every year.

Compounding interest can work for or against you, depending whether you’re earning compound interest on an investment or paying compound interest on debt. Of course, some debt (like student loans or a mortgage) is okay, while other debt (hire purchases, Afterpay, credit cards) is unnecessary and can cripple you financially. The book Money Made Simple by the founder of Simplicity, Sam Stubbs, illustrates this with a simple example: “If you didn’t repay anything, $10,000 borrowed at 10% adds up to a total of $25,937 after 10 years. That means you would have to repay 2.5 times what you borrowed. At 18% interest (which is what many credit-card companies charge), it would add up to $52,338 after 10 years, and you would have to repay 5.2 times what you borrowed.”

Let’s look at it how compounding can help you save more money over time:

The information provided and opinions expressed in this article are intended for general guidance and are not financial advice or a recommendation. Simplicity NZ Ltd is the issuer of the Simplicity KiwiSaver Scheme and Investment Funds. For Product Disclosure Statements please visit Simplicity’s website: simplicity.kiwi.

Simplicity is a low-fee, nonprofit KiwiSaver provider (owned by the Simplicity Foundation), committed to making everyday Kiwis richer and smarter with money.