Using compound interest without unrealistic assumptions

Compounding means each period's return is added to the balance and can itself earn a return in later periods. Regular contributions enter at different times, so money added near the beginning has longer to compound than money added near the end.

A calculator may assume contributions are made at the start or end of each month and that the annual rate is applied evenly. Real savings accounts can calculate interest daily and pay it monthly, while investments move irregularly and can experience negative periods.

For a savings account or term deposit, use the actual rate and check whether it is introductory, conditional or variable. For an investment, the entered return is a scenario rather than a promise. Historical averages do not guarantee the next year or the sequence in which gains and losses occur.

Run conservative, middle and higher scenarios. If the plan only works at the highest rate, that is a warning about the plan rather than evidence that the higher rate will happen.

Fees reduce the amount left to compound. Tax can also reduce the return depending on the investment, ownership and personal circumstances. Inflation reduces purchasing power even when the displayed balance increases. A nominal future balance should therefore not be confused with what that money will buy.

Record the assumptions beside the result and treat the outputs as a range of possible outcomes. The most valuable insight is often not the final balance but how the outcome changes when contributions, time, fees and return assumptions are adjusted one at a time.