Compound Interest: What is it, how do you calculate it and can it contribute to saving?

According to an annual survey conducted by the Public Opinion Research Centre (CBOS), in 2022, as many as 58% of surveyed Poles declared having savings, compared to 23% in 2007. Despite the significant increase in the number of savers, Poles are still reluctant to invest their money, which loses its value over time. It is well known that inflation is the enemy of savings and investments. Rising prices of goods and services reduce the purchasing power of the money and force people to look for ways to secure their savings. In recent years, the purchase of real estate has been a particularly popular way to invest savings among investors managing larger amounts of capital. This was facilitated by low interest rates and relatively cheap housing loans. However, property prices have also risen significantly in a relatively short period of time and the increased interest rates in recent months contributed to an increase in the amount of mortgage instalments. As a result, the creditworthiness of buyers has decreased and the number of new loans granted fallen. Nowadays, the purchase of a property involves even more funds.

Due to the inflation, money kept in a piggy bank at home or at a regular personal account will diminish in value over time. According to the Ministry of Finance’s inflation calculator, PLN 10 000 accumulated in June 2002, 10 years later had a purchasing power of PLN 7 528.53, and 20 years later, in June 2022, only PLN 5 729.80. Despite the fact that money depreciates over time, it makes sense to start saving as early as possible for two reasons. Firstly, the earlier you start the more you will set aside. Secondly, systematically deposited funds that are at the same time properly invested will accumulate over time and increase capital like a snowball. This is facilitated in particular by the use of financial instruments based on the compound interest mechanism.

Compound interest can be defined as a type of return on a money deposit that earns interest on the interest over time. In case of fixed-term deposits, the interest accrued for a given period using a certain interest rate is not paid out as profit, but is added to the capital contribution. This adds up to the higher profit that the money will generate over the next savings period. Thus, the longer one saves, the higher the profit per month, quarter or year. Although this might be tedious process, in the long term it allows to earn more income than with a fixed interest rate deposit, where, once the interest on the deposit or savings account is capitalised, the profit is transferred to a designated bank account.

Compound interest formula:

Final amount = initial amount x (1 + interest rate) ^ number of investment periods)

For example, by putting aside PLN 300 every month on a long-term deposit with an interest rate of 2% per year, where the profits are capitalised monthly and added to the capital, after 10 years we will accumulate PLN 39 051, where the contribution alone is PLN 36 000 and PLN 3 051 is profit. By putting aside the same amount for 20 years under the same conditions, we will collect almost PLN 85 000, where our contribution is PLN 72 000 and the profit is PLN 12 965. On the other hand, if we save for 30 years, our contribution would amount to PLN 108 000, and the profit would be PLN 30 947, which gives a total of almost PLN 139 000. In comparison, by setting aside twice as much, i.e. PLN 600 per month on a deposit with the same interest rate and monthly capitalisation for 15 years, we would collect PLN 122 159 of which PLN 14 159 is the profit. Therefore, in case of compound interest, saving the same amount (PLN 108 000) in the long run is more profitable, as it generates more proceeds.

Compound interest can also be helpful in developing strategy for playing the stock market. This mechanism is used in the swing trading method, which involves buying and selling the same instrument at a high frequency depending on its fluctuations. In the meantime, the money earned are reinvested, making capitalisation happen over and over again. The compound interest mechanism is also used by securities that pay interest on an ongoing basis, such as shares, which pay dividends, or bonds, that pay coupons to their investors. Still investing in the stock market is much more risky than placing funds in bank deposits and a good knowledge of the market, investment rules and financial instruments is required.

The construction of the mortgage loan is also based on compound interest to some extent, but the mechanism is reversed – interest is charged on the total amount of the loan from the first day of repayment. As a result, the borrower pays back up to twice the amount borrowed. In contrast to saving, where the mechanism of compound interest accelerates with time and the increasing amount of capital, in case of a loan, repayment is designed to stop this process. Therefore, the shorter the repayment period, the lower the cost of the loan.

Compound interest can be used for saving as well as investing and borrowing, and the effects of the mechanism may or may not be beneficial. It usually takes time to see the results of saving forasmuch the process is laborious. When using compound interest, it is important to be systematic and patient. Even if the return rate is low in the first few months or years, it is crucial to continually reinvest the money. The real power of the investments made is noticeable after several years. Nowadays, while inflation reaches 15% it will be rather difficult to achieve a return that brings our savings up to the level of inflation without high cash outlays or the burden of the investment risk. However, we can reduce the loss by properly investing capital, for example in financial instruments offered by banks. The increase in interest rates made by the Monetary Policy Council of the National Bank of Poland gives hope for more favourable conditions for investing and multiplying capital in banks.

Marta Polkowska
SARFiN System Data Administrator
Senior Maintenance and Development Specialist