Compound interest – how to make interest work for you

In times like these, with the cost of daily living on the rise, it is important to have savings – especially given the unpleasant surprises that life invariably brings. If the washing machine, the refrigerator, or something else breaks down, you don’t want to wait forever to buy a new appliance. It is easier to quickly fix a sudden problem if you have put aside a little money than if you have nothing or not enough.

But what to do when money is tight? Creating a cash reserve is already possible with small amounts starting at EUR 50. And let’s be honest: maybe there is something you can do without for once in order to do the right thing for your own future? However, if you can raise those EUR 50, it is not yet clear how you can double or multiply it.

Hooray – interest is back!

The first thing you need is interest. The good news: interest is back again! Anyone who already has a savings book knows that interest rates have been meagre for many years. Since 21 July last year, things have changed. That’s when interest rates started to rise sharply. The reasons are obvious: the strong inflation, especially because of the high energy prices and the costs of daily living. After the start of the Ukraine war, inflation intensified: food prices, costs for restaurant visits, etc. also skyrocketed.

The interest rate policy, i.e. deciding whether key-lending rates rise or fall, is the task of central banks such as the European Central Bank (ECB). The ECB is responsible for the countries that have the euro as their currency. By raising rates, central banks such as the ECB try to curb inflation. They pursue an inflation target of no more than 2% per year. While we are miles away from that today, we have also come a long way back from the high in the winter months, albeit not to the same extent across the board.

Interest is the price of borrowing money. That there is now some (interest) again is a good sign. The fact that it was at zero for years was a consequence of some crises that happened a while ago.

Benefiting from interest and compound interest

Interest ensures that the money in the savings account or invested in securities grows. If you have already saved or invested some money, you will receive interest on the interest again. This is compound interest. Compound interest makes your money grow even faster, especially if you don’t touch the money for years and interest rates are high.

A primer on the compound interest effect

We make a lump-sum deposit of EUR 100. After one year, the bank pays us interest on our money. At 1% we have EUR 101 after one year, at 2% it is 102 etc. (please refer to the table). The capital gains tax, which is normally deducted from this interest, is being disregarded for the purpose this example.

If you leave the EUR 100 in the deposit, the amount of money that earns interest in the second year grows. As a result, you get interest on the interest. In the 1% example you are at EUR 102 after two years. After five years you are at EUR 105 and after ten years more than EUR 110, (please see the table). This is called the effect of compound interest.

	Deposit	Interest (rate)
Today	100	1%	2%	5%	10%
1		101.000	102.000	105.000	110.000
2		102.010	104.040	110.250	121.000
3		103.030	106.121	115.763	133.100
5		105.101	110.408	127.628	161.051
10		110.462	121.899	162.889	259.374
20		122.019	148.595	265.330	672.750
30		134.785	181.136	432.194	1744.940

If the interest rate is not 1% but 5%, for example, the amount grows to EUR 127 after five years and to more than EUR 162 euros after ten years, and to an impressive EUR 432 after 30 years, thanks to interest and compound interest alone. You haven’t paid in a single additional cent. The higher the interest rate and the longer the savings period, the higher the return earned with interest and compound interest.

How EUR 10 turns into 100

To turn EUR 10 into 100, i.e. to increase the amount paid in tenfold, two things are necessary, as our calculation shows:

• A high annual interest rate of almost 8% (including compound interest)
• A long holding period of 30 years

	Initial value	10
Years	Future value	100
1	Compound interest	900.00%
2	Compound interest	216.23%
3	Compound interest	115.44%
5	Compound interest	58.49%
10	Compound interest	25.89%
20	Compound interest	12.20%
30	Compound interest	7.98%

How do you do that? Only with securities and more risk. You have to be ready for it, and you also have to have the necessary time! But basically, it’s not witchcraft. You open a securities account at the bank, something similar to a deposit account except that it is just for securities. The general motto is: don’t put all your eggs in one basket, i.e. don’t buy just one asset. Instead, spread the risk over many. How does that work? Funds, for example, can be a suitable option. With funds, you can spread your money over different assets when you buy a share for as little as EUR 50. If you follow the five golden rules, there is not much that can go wrong.

Conclusion

If expenses are high and money is tight, good advice is hard to come by. Putting some money aside not only makes sense to have reserve funds to call on when needed. Thanks to interest and compound interest, the amount grows year after year. In order to improve the earnings potential, investing and a fund savings plan can be a promising option.

For a glossary of technical terms, please visit this link: Fund Glossary | Erste Asset Management

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Prognoses are no reliable indicator for future performance.

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