So you may have heard of this magical, financial eighth wonder of the world. but what is compound interest and how does it work?
What Is Compound Interest?
Simple, it’s just; A = P (1 + r/n) (nt)
- A = the amount of money accumulated after n years, including interest
- P = the principal amount (your initial deposit or your initial credit card balance)
- r = the annual rate of interest (as a decimal)
- n = the number of times the interest is compounded per year
- t = the number of years (time) the amount is deposited for
Ok, so that’s a little confusing, right? Let’s break it down:
“Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest. Wikipedia”
Money makes money.
…If it’s in the right place that is. If your money is in the bank, you’ll be hard pushed to beat inflation which is currently at 5.1%, it’s been a long while since regular banks were dishing out that sort of interest rates on their accounts. So it really matters where you store your money. Einstein apparently once said that compound interest is the eight wonder of the world, so let me explain to you how amazing it is for your money.
“The real route to riches is to set aside a portion of your money and invest it, so that it compounds over many years.”
With compound interest, you’re not just earning money on your initial savings balance through interest, that interest is then added to the initial balance and it also earns interest. The interest is compounding on top of the other interest and over time this will rapidly increase value.
If you were to put £1,000 in to an investment with a yield of 7% (the average stock market return for the last 30 years is 10.72% (8.29% when adjusted for inflation)) and just left it there and did nothing to it for 25 years, after that time it would be worth £5,725. Sounds alright I guess? But, if you keep adding to that amount the end figure would blow your mind.
Suppose your initial deposit is £1,000 and you can add in £500 per month, in 25 years you will have put in £260,000 of your money. But, with an average rate of 7% compounded annually you will get over £150,000 back interest alone, making your total £410k! – magic, right?
If you can invest that over 40 years, it will be worth over £1.3million! The magic of compound interest.
The interest on the interest which is gaining you money.
Ok, so maybe you can’t afford £500 every month, but if you are going out for dinner, clothes shopping or spending on coffee everyday, you can easily save £200 and in my opinion this is well worth the short term sacrifice.
But, what if you’re wondering what is compound interest in terms of debt? Unfortunately, it’s not always good news – it will also expand any debt you have over time, just as it does in a positive way with your savings, interest on debt will add up and you will pay back much more over time which is why credit card debt can quickly rack up.
With compound interest, time is everything. The sooner you start saving or start investing, the longer you give that money to grow, and the more it will be worth at the end of the term.
What do you think? Does this make you look at your savings differently? Don’t forget you can get your free financial planning sheets here.
Disclaimer, I am not a financial advisor, this is not financial advice so do your own research, your capital is at risk. 🙂
What do you think?