How does saving money grow?

Choosing later over now

Saving means keeping some of your money now so that you can use it later. That sounds simple, but it is a real skill, because spending is more fun in the moment. Moneysmart, the money-education website run by the Australian Government, suggests starting with the difference between needs, things we must have such as food, a home and clothes, and wants, things we would like but can live without.

The next step is a goal. Saving for something you really want, such as a bike or a game, makes it much easier to say no to small things along the way. Small amounts add up faster than you might think. Put aside $5 a week and you will have $260 by the end of the year, with no help from a bank at all.

A piggy bank works well when you are young, because you can watch the coins pile up. As you get older, a savings account adds something a money box never can: interest.

What is interest?

Interest is a payment for the use of money over time. When you put money in a bank, you are really lending it to the bank. The bank lends that money out to other people, for example to families buying a house, and charges them interest. It pays part of that back to you, as a thank-you for letting it use your money.

Interest is written as a percentage per year, called the interest rate. If your account pays 5 per cent a year and you have $100 in it, you earn $5 over the year. Your original $100 is called the principal. Many savings accounts work out the interest every day and add it to your balance once a month.

Interest works the other way too. If you borrow money, you pay interest to the lender. That is why grown-ups care so much about interest rates: they decide how fast savings grow and how much loans cost.

Interest on your interest

Here is where it gets interesting. After the first year, your $100 at 5 per cent has grown to $105. In the second year, the bank pays 5 per cent on the whole $105, not just on your original $100. That is $5.25, so you end the year with $110.25. In year three you earn $5.51 and reach $115.76.

Earning interest on your interest is called compound interest. The extra amounts look tiny at first, but they snowball. After 10 years your $100 is worth $162.89. After 20 years it is $265.33. If the bank had only ever paid 5 per cent on the original $100, which is called simple interest, you would have just $200 after 20 years. Compounding earned you an extra $65 without you lifting a finger.

Moneysmart gives a bigger example. Save $10,000 at 3 per cent a year, with interest added monthly, and after 20 years you would have $18,208. More than $8,000 of that is interest. The lesson is the same at any size: the longer money stays saved, the harder compounding works. That is why starting early matters more than starting big.

The rule of 72

Want a quick way to guess how long money takes to double? Divide 72 by the interest rate. At 6 per cent a year, 72 ÷ 6 = 12, so your money doubles in about 12 years. At 4 per cent it takes about 18 years, and at 8 per cent about 9. It is only an estimate, but a surprisingly good one. Check it: $100 growing at 6 per cent for 12 years comes to $201.22.

Regular saving supercharges the effect, because every new deposit starts compounding too. Suppose you save $260 a year, that $5 a week, for 10 years. Without interest you would have $2,600. At 4 per cent compound interest you would have more than $3,100. The difference is money the bank paid you.

Keeping savings safe

Is money in a bank safe? In Australia, banks, credit unions and building societies are closely supervised, and the Australian Government's Financial Claims Scheme protects deposits up to $250,000 per person at each institution, in the unlikely event that one fails. That is one reason an account is a safer home for savings than a shoebox under the bed.

There is one thing to watch. Prices tend to rise over time, which is called inflation. If prices rise by 3 per cent in a year and your savings earn 2 per cent, your money buys slightly less than it did, even though the number has gone up. Interest rates go up and down, so when you are old enough to open an account, compare what different accounts pay and read the conditions, with a grown-up's help. Then let time do the rest.

📚 Words to know

Interest

A payment for the use of money over time. A bank pays you interest on savings; you pay interest when you borrow.

Principal

The amount of money you start with, before any interest is added.

Interest rate

How much interest is paid each year, written as a percentage of the balance.

Compound interest

Interest paid on your original money and on the interest you have already earned.

Deposit

Money you put into a bank account.

🧪 Try this: watch compounding snowball

1. You need two jars, about 400 small counters such as dried beans or pasta shells, a pencil and paper. Each counter is worth $1. Put 100 counters in each jar: that is your $100 principal.
2. Jar A pays simple interest. Each 'year' (one round of the game), add 10 counters: 10 per cent of the original 100. Jar B pays compound interest. Each round, count what is in the jar, work out 10 per cent of that, round it to the nearest whole counter and add it.
3. Play 7 rounds and write the totals in a table. Jar A goes 110, 120, 130 and so on up to 170. Jar B goes 110, 121, 133, 146, 161, 177, 195. Jar B has nearly doubled, right on the rule of 72's prediction, because 72 ÷ 10 is about 7.
4. Try again with 5 per cent, or add 20 counters at the start of each round to see what regular saving does. Then, with a grown-up, try the Moneysmart compound interest calculator with real numbers.