Compounding returns

Compounding returns (commonly described as “compound interest”) are an important concept in the financial world. In simple words, the concept means that you receive investment earnings on not just your principal amount but also on the prior investment earnings from that amount. Compounding returns differ from simple interest, which is calculated only on the initial principal amount or deposit.

Time is really of the essence when it comes to compounding returns as you reap the benefits in the long term, which means that the longer your money is invested, the more time it will have to grow. It especially works well if you are saving for the long term (for example retirement) or towards your medium-term goals like a first home deposit. The earlier you start, the more you can save for those goals. Compounding returns work well in situations where there is rising inflation, which decreases your buying power over the years.

For example, imagine you invest $10,000 in a five-year term deposit with a fixed interest rate of 5% a year (paid annually) and your withholding tax rate (the rate of tax you pay on the interest earned) is 33%[1]. At the end of the first year, you will receive after-tax interest of $335 ($500 less $165 tax), meaning you now have $10,335 in the account. If you keep that $10,335 invested in the account, at the end of the second year you will receive after-tax interest of about another $346 - that’s $335 on your principal amount and $11 on the interest you earned in the first year. If you keep the money invested as well as making extra contributions, it will exponentially increase your earnings over the long term. KiwiSaver and other retirement schemes incorporate compounding returns, as you cannot withdraw your funds until their rules allow it, which makes your money grow over the years. 

The Sorted website has a great tool to find out how compounding earnings make your savings grow over the years: Savings Calculator » Sorted

[1] This rate varies depending on your tax status, the type of interest or   dividends you earn, and the information you give the bank – the 33%   rate used here is solely illustrative.