It’s not referred to – allegedly by Albert Einstein – as the eighth wonder of the world for nothing.

And if you’re not using compound interest to superpower your finances, you’re probably missing out.

Here’s what you need to know.

What is compound interest, anyway?

Compound interest refers to the process of interest attracting interest.

To put it simply, without factoring in tax or any fees, if you had $10,000 in an account that paid 5 percent a year, after the first year you’d have $10,500 (before any tax is deducted).

But the second year, you would then earn interest based on your new balance including interest – so your balance would grow to $11,025. There is an extra $25 that has been earned in interest, on the interest you earned the previous year  – compounding in action.

You also hear compounding referred to in the context of returns, such as from investments in managed funds or KiwiSaver.

As Sorted notes, compounding returns can be a good way to help your investments keep ahead of inflation, and stop their value being eroded by the growing cost of living over time.

Why does it matter?

Compound interest can be a hugely important concept for investors because it can enable them to grow their wealth well beyond what they could contribute on their own.

Depending on your investment time horizon, it could be worth tens of thousands of dollars.

But on the flipside, if you withdraw money from an investment, you reduce your compounding potential, so the impact on your final income can be larger than simply the amount of money withdrawn. This may need to factor into your calculations if you plan to access a stream of income from your portfolio before you access the full amount.

Put it to work

Compounding returns works best over long periods of time, so if you are a young saver or investor, it can be a valuable tool to get working for you.

It’s the reason why you may be able to achieve better outcomes than someone who starts saving or investing later, even if they are able to put aside more money than you.

This can be really helpful when it comes to retirement planning. Your KiwiSaver investment stands to benefit a lot if you can let compounding work its magic on your balance.

A 20-year-old starting in KiwiSaver and saving 3 percent plus an employer’s 3 percent of a $65,000 salary would be on track to save about $380,000 by retirement in a growth fund, according to Sorted’s calculator.

Someone who started at 40, earning $100,000 and with the same contribution and fund settings would only have saved $212,000.

It is important to keep in mind that returns won’t necessarily be consistent over time, particularly if your money is in more volatile assets for a long period. Some volatility should be expected.

Are your investment settings right?

If you would like to check whether you are using compounding returns or compound interest as efficiently as possible – or have any other questions about how your investing decisions may affect your outcomes, contact your SHARE adviser. We can help you work through your options and determine whether your settings are appropriate for your needs.

Disclaimer: Please note that the content provided in this article is intended as an overview and as general information only. While care is taken to ensure accuracy and reliability, the information provided is subject to continuous change and may not reflect current developments or address your situation. Before making any decisions based on the information provided in this article, please use your discretion and seek independent guidance.