INSIDE INVESTOR: How compound interest can work for your goals

Have you ever marvelled at how the most annoying aspects of your time in the classroom all those years ago suddenly become profoundly absorbing as you mature?

Calculating interest on loans is a good example, particularly when you understand that the difference between simple interest and compound interest, once of no interest at all, can become the foundation for wealth creation.

Simple interest is the rate paid as and when it falls due on a loan. By contrast, compound interest is interest paid on the loan and on the accrued interest from the previous period.

So by reinvesting rather than collecting the interest on a deposit, an automatic multiplier is built in to your initial investment that will help boost its value over and above the rate of inflation.

The Australian Securities and Investments Commission has a neat little calculator on its website that allows you to figure out how much compound interest you will earn on, say, a $20,000 deposit over five years at five per cent interest. It works out that your deposit would have grown by $5,526.

You can adjust the input numbers to work out how much you would have to contribute to meet a certain savings goal in a certain time frame.

A similar process can be applied to the stock market. Most companies have what is known as dividend reinvestment plans and in the early stages of your investment life you should aim to live off your earnings, rather than spend the dividends, and allow your dividends to buy extra shares.

While the stock market is far less predictable than term deposits, it does tend to rise over time and if you have invested in good, solid companies with attractive dividend yields, you should make a tidy capital gain over the longer term.

Like everything in life though, compound interest can have its downside, especially if you are on the other side of the ledger.

If you are a borrower, rather than a lender or investor, and you fail to make repayments on time, a bank will have no qualms about capitalising your interest into your loan. When that happens you will be paying interest on the interest payments you failed to make as well as on the original principal you borrowed.

And you could be slugged with higher penalty rates just for good measure. That explains those court cases you often read about where a person or corporation in financial strife, and unable to repay debt, discovers the original loan has headed into the stratosphere.