Albert Einstein is reputed to have said that ‘Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t pays it.’
Now Albert Einstein was smart guy. But whilst you may have heard of the term ‘compound interest’, a pretty big number of us don’t understand what it means, or how it has the power to change our lives.
That sounds insane but, compound interest really can make your wealth snowball and help you save hundreds of thousands, or even millions, of pounds.
Compound interest can make your wealth snowball
It’s a concept you need to get your head around and once you do, you’ll feel as if the door to a financially successful future has just been opened. I know. I literally can’t explain how incredible compound interest is.
You can use our free compound interest calculator to see how much you need to save and for how long, to reach your financial goals.
What is compound interest?
Keeping it simple, compound interest is interest earned on interest.
Being a bit more detailed, it’s where interest is calculated on the initial amount of money you have, and all interest already earned on that money.
Here’s an example to help explain it:
You put £100 in a savings account which offers a 10% rate of interest.
At the end of the first year, your savings pot is now £110 (£100 starting amount and £10 interest).
The following year the 10% interest rate is earned on your now bigger pot of £110.
At the end of year two, your pot is £121 (£110 starting amount and £11 interest).
At the end of year three, your pot is £133.10 (£121 starting amount and £12.10 interest).
See how the amount of interest earned grows each year as it’s applied to a greater starting amount?
After 10 years, your starting amount of £100 would have grown to £259.37.
After 20 years, your starting amount of £100 would have grown to £672.75.
After 30 years, your £100 would have grown to a whopping £1744.94.
And you did nothing but leave £100 in a savings account earning 10% interest.
Time is the magic ingredient
You’ll see from the example above that your pot grows quicker between 20 and 30 years, than it did between 10 years and 20 years. This is because it snowballs over time, as the interest payments significantly increase.
It’s best understood visually. You can see it in action in the chart below – see how the interest earned curve (bright blue blocks) gets steeper over time but the grey blocks – your £100 investment – remain level?
To take advantage of compounding, you need to keep your savings in place for as long as possible. The benefits of compounding don’t really kick in during the first 5 years. The longer you have you let your money grow, the greater the return.
To take advantage of compounding, you need to keep your savings in place for as long as possible.
Add to your starting pot and earn even more money
There’s no denying the returns on a £100 investment as shown above, are pretty spectacular over a long time period.
But, if we take our original example – £100, saved in an account paying 10% interest over 30 years – well £1744.94 isn’t going to allow me to quit my job and kick back on a sun-lounger.
What if – as well as our starting amount of £100 – we could also put in another £100 a month?
Here’s what happens if we do that:
Just look at the amount of interest you have earned, versus the amount of money you have put into the account – that’s phenomenal.
With the total pot being at almost £210k, the sun-lounger is looking more likely!
The interest rate is just as important
Just as the amount of money you earn multiplies with time, the same is true of the interest rate. For example:
£100 in a savings account at 2% interest for 30 years: £181.14
£100 in a savings account at 4% interest for 30 years: £324.34
£100 in a savings account at 8% interest for 30 years: £1006.27
I know which account I want my money in!
Always hunt out the best interest rates for your savings and investments, as it can have a significant impact on how much your money grows.
Combine regular savings with the highest interest rate you can find to maximise your returns.
Take advantage of compound interest now
To more easily accumulate wealth, you need to start saving as soon as possible and save regularly. It’s better to put what you can into an interest earning account now, than it is to wait until you have more money to save. Even £25 a month can grow to a pretty decent pot of money over 30 years. Compounding needs time to kick in.
To get started you can:
- Increase contributions to your employee / workplace pension
- Open a SIPP pension and put money in there
- Use a Cash ISA or Stocks and Shares ISA
All of these are tax-efficient accounts, meaning you pay no income tax on the interest you receive, and any profits are free of Capital Gains Tax. There is a limit on how much you can put into these accounts each year though, so make sure you do your homework before opening one.
Remember that interest rates are important too. A Stocks and Shares ISA will likely offer a much better return than a Cash ISA – but your pot is more at risk as its value may go down as well as up. Only you can decide your risk levels.
Watch out – compound interest can also work against you
If we return to the Einstein quote at the top of this article, you’ll see the key is to earn it – not pay it. Compound interest can, in the same way it works for you, work against you.
Whenever you borrow money, you pay for the privilege in terms of an interest rate, which is charged on top of your borrowing. If we take a simple credit card example –
You borrow £2000 on a credit card, which is charging interest at 24% APR.
24% APR means you are charged 2% on your borrowing each month (24%/12 months).
The interest you are charged for the first month would be £40.
That is added to your £2000, so the balance you owe is now £2040.
The next month, you would be charged £40.80 interest on that higher balance.
In month 3, you would be charged £41.62 in interest.
See how the interest charged is slowing increasing each month?
This example doesn’t take into account any payments you make towards the debt and it’s true that any payments would decrease the effect of compounding.
However, if you are only paying the minimum payment each month, it will be hard to keep up with the compound interest you are being charged.
If you were to pay a minimum payment of £50 in month 3, that £50 would only pay off £8.38 of your debt – the rest goes to the £41.62 interest charge. It’s going to take a very long time to clear that debt.
Bottom line – you don’t want compound interest to work against you.
The Rule of 72
If you haven’t got immediate access to our compound interest calculator, you can use the rule of 72 to estimate how long it would take to double your money.
The Rule of 72 takes the interest rate you expect to receive and divides it into 72. The result is the number of years it will take to double your money, whatever your initial investment amount.
Let’s use a nice 8% return. 72 divided by 8 = 9. Therefore, it will take 9 years to double your money.
If you have £10,000 invested, it will take you 9 years to double your money to £20,000.
It will then take another 9 years to double that £20,000 to £40,000.
If your investment is locked in for 27 years, you will have a nice £80,000 pot.
36 years at 8%, and your initial £10,000 has grown to £160,000.
The power of compounding is real!
So that’s compound interest explained. I hope you’ve been able to grasp the concept. It really is that easy to build wealth, if you can make decisions that take advantage of the power of compounding over time.
Do you see now how it has the power to change your life?