Heard about compound interest?
It can be a friend or a foe, and if you have a savings account and a mortgage like most Australians, then compound interest has already had an impact on your finances – for better or worse.
Compound interest is a powerful tool that can work for you, or against you (which actually means it’s working for somebody else, usually your bank!).
It has the power to increase your equity and cash position, but can also cost you dearly on your loans.
So where should you stash your extra cash– in your savings or onto your mortgage?
You’ll need to consider that question in light of your own situation, so let’s look at the power of compound interest a little more closely.
1. Savings accounts and long-term investment accounts:
Here, compound interest is your friend because it makes money for you.
2. Home loans, car loans, credit cards etc:
Here, compound interest is working against you, because it adds more money to the loan that you ultimately hope to pay off.
To truly understand the impact this can have on your finances, you need to understand how compound interest is calculated.
Now if, like many, you groaned your way through Year 10 maths, don’t despair – the principles of compound interest are surprisingly simple.
Compound interest can appear complex because it requires a formula to work out.
The formula for calculating compounding interest may even baffle Einstein, so if you’re really interested I’d advise you to take advantage of the many free compound interest calculators available online.
If only we had those back in Year 10!
Anyway…I’ll show you how compound interest works and how it can benefit you and your savings.
Say you have $10,000 in the bank with 5% compound interest, calculated daily and paid into your account every month.
During the first month, $41.75 interest is deposited into your account.
The following month, your 5% interest applies to $10,041.75, so you’re actually earning interest on your interest.
By the six-month mark, you have earned $253 in interest and the 5% will apply to $10,253.
By the end of the year, your total is $10,512.
After 30 years you would have $44,812, without depositing a single extra dollar into the account.
That’s the joy of compound interest.
As this demonstrates, adding even small amounts to your savings investment can make a huge difference in the long run.
The earlier you can begin your investing journey, the better your potential for return, because it allows more time for the interest to compound and accrue.
Now of course in that example I’m using the interest rate of 5%, which is a little high at present and even so it’s much more realistic to expect that interest you’ll receive will increase and decrease over time in line with market rates.
Obviously, the higher the interest rate, the better the return on your savings account.
On the down side, a higher interest rate will definitely cause your mortgage some grief.
How compounding interest can load up your debts
Apparently the average home loan is for a 30-year term.
When you calculate the amount of compounding interest that applies over that span of time, it’s a fair chunk of money on top of the cost of your home.
For example, a home loan of $450,000 with an interest rate of 5.75% will cost you $464,700 in interest over a 30-year term.
Yes, that’s more than the initial loan amount!
So you can see why it’s so important to reduce your mortgage quickly with extra repayments.
Paying off a little extra in the first few years can save you a bucket of money in the long run, since there is less money in your loan for compound interest to accrue on.
Here’s another important point: earlier I mentioned car loans, credit cards and personal loans.
These forms of borrowing attract much higher interest rates.
So my advice would be to always knock down your personal (non tax deductible) debt as a priority, as there’s little point in accruing 5% interest on your investment account while you’re paying 14% interest on your car loan or 20% on a credit card.
It’s always ideal to get rid of the ‘bad debt’ first.
Let’s get back to our original question:
So in the long run, is it better to focus on putting your money into savings to earn interest, or should you pay off a loan to decrease the interest?
Even armed with all that information, the answer to that question can still a blurry one.
Generally speaking, mortgage interest rates are higher than savings account rates.
Presently, most banks are offering mortgages with interest rates between 4-5%, while savings accounts at these same institutions are in the 2-3% range.
Therefore, it would seem to make more sense to put more money into your mortgage (reducing 4-5% of compounding interest payments) than to put that money into savings (earning you 2-3% worth of interest).
And remember you pay your mortgage with after tax dollars, so you may have to earn $1,500 or $1,600 to be left with $1,000 to pay off your mortgage and you have to pay tax on the interest you receive – so you may only be left with $75 of the $100 you earn in interest.
However, this is a simplistic answer, as it fails to take into account your tax rate; whether your mortgage is for investment or owner-occupied home; your ability to offset your loans; and much more.
This means it’s worth taking the time to crunch the numbers and work it out for yourself.
But for most people the best answer is to stash your savings in an offset account (a type of savings account) linked to your home mortgage.
Instead of receiving interest on the savings (offset account) you only pay interest on your home loan balance minus the amount in the offset account.
The more money you have in the account, the less interest you pay on your home loan, plus you have easy access to your funds if ever you need them again.
If you need help, a financial adviser can run the numbers for you.
Also published on Medium.