“Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.” Albert Einstein.
What is compound interest?
The beauty of compound interest is that it allows you to earn interest on your interest. While you have to sweat to earn the money you initially invest, from then on your money works on your behalf. The earlier you start, the more interest you can earn on your interest, on your interest, on your interest, on your interest…! You get the idea.
It’s hard to comprehend the impact of compound interest; the chart at the top of the page illustrates how the value of your money can grow exponentially given enough time. The following examples will also give some indication of how important starting early can be to making your money work for you.
Example 1: Anna as a 20 something-year-old invests £1000 at an interest rate of 10% and then forgets all about it. In just 20 years with the magic of compound interest, the value has grown to nearly £7,000, but as more years go by, the growth is exponential. By retirement age, without adding any more money, the value has grown to £88,000 as shown in the chart at the top of the page. It’s like a snowball rolling down a hill, the longer it rolls the bigger it gets - exponentially.
Example 2: Conor at 20 invests £10,000 and forgets all about it until he retires. Assuming a 6% compounded annual return on that investment:
• At retirement it will be worth £138,000.
• If the investment is delayed by ten years, the end sum will be £77,000.
• If the investment is delayed by 20 years, the end sum will be just £43,000!
The initial growth in the first years is the hardest part, after this, compound interest does the hard work.
The rule of 72
The rule of 72 is generally used to determine how long it would take for an investment to double in value given the annual rate of return. At a 6% compound growth rate, it will take just 12 years for the portfolio to double (72/6=12 years).
Example 3: How to become a millionaire using the power of compound interest!:
20 year old Carol sets up a direct debit for £190 per month and invests in the FTSE100. She then forgets all about it and lives life to the full. Based on historical figures, when Carol goes to collect that pot of cash at retirement it will be worth £1 Million.
If the £190 per month is increased each year in line with inflation, this will be a ‘real value’ of £1 Million.
If Carol has the option of investing in a company pension scheme and her monthly amount is matched by the employer (More about this in a later blog), to retire with £1 Million, Carol has to pay just £76 per month!!
Compound interest table
Example 4: Do not underestimate the power of compound interest and the value of starting early. The table below shows £1,000 invested at 10% compound interest and left alone to grow exponentially given time:
This shows how significant it is to start early…remember the 50/30/20 Budget…save whatever you can afford and increase this when you can. Benefit from the magic of compound interest.
Spend less than you earn. Pay yourself first. Automate.
Final Word: Don’t forget….Debt compounds too!