Einstein once reportedly referred to compound interest as the ‘eighth wonder of the world’, stating: “He who understands it, earns it, he who doesn’t, pays it”. So, just what is compound interest and when do you benefit from it?
Whilst financial jargon can often seem complex, compound interest is actually simple and easy to take advantage of. The term refers to the principle that when you save money you can earn interest on not only your initial contributions but on the interest itself. So, if you leave your money in a savings account for an extended period of time, the amount of interest earned can grow significantly. As a result, the rate that your savings grow gets faster.
Let’s say you deposit £1,000 into a savings account that pays 10% interest a year. In that first year, you’d earn £100 in interest. However, if you leave both your initial saving and interest, the following year, you’d receive £110 in interest. The more frequently interest payments are made, the greater the effects of compounding.
The same principle can be beneficial when you’re investing too. Investing returns delivered means they can go on to potentially deliver returns themselves.
Why is compounding so important?
Compounding means that even if you don’t add to savings and investments, they can continue to grow. Over a long period of time, this can lead to a substantial financial boost as interest or returns accumulate. This can be highlighted by looking at how pension contributions accumulate over different time periods.
Past research has demonstrated how saving into a pension for 10 years at the beginning of your working life could result in a bigger pot than saving for four decades. The study assumed annual pension contributions of £2,500 and investment growth of 7% a year:
- Someone that starts saving at the age of 21 and then stops at 30 would have a pension fund worth £553,000 by the age of 70 if no further contributions were made and gains were reinvested. This is after contributions of £25,000 grow by a factor of 22 over the long term.
- In contrast, someone saving from 30 until retiring at 70 would have a pension of £534,000. By saving later in life, under this scenario, people contribute £100,000 to their pension but it grows by a little more than fivefold.
Another way to visualise the effects of compound interest is to think about how long it would take to double your money if savings were benefitting from 10% interest. If you answer quickly, your response might be ‘ten years’. But with compound interest having an effect, it takes just seven years.
When does compound interest matter to you?
As compound interest has the greatest effect over the long term, the impacts will be most felt on the financial areas where you’re looking to the future. This may include:
- Long-term saving accounts
- Investment portfolios
- Savings for children or grandchildren
It can be difficult to calculate the full impact of compound interest, particularly when investing, but there are calculators available online. Simply knowing that leaving interest and returns untouched can boost your savings can help you take advantage of compounding.
Understanding compound interest can help you get the most out of savings. For a comprehensive financial review, please get in touch with us.
Please note: The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation, which are subject to change in the future.