Compound interest – what it is, and why you want it on your side
It’s been said that there are two types of people in the world: those who understand compound interest and those who are doomed to pay it. In this article we’ll investigate what that means and whether or not it’s actually true.
First, we need a definition of compounding and compound interest. When your interest is compounded it means that it is added back to your original capital, from which point it then starts to earn interest itself. To clarify this, let’s take as example the unlikely scenario that you find a savings account paying 10% interest annually, in which you decide to invest £1,000.
You might initially think that this means you will make £100 in interest per year, and to an extent you’re correct. That’s certainly what you’ll make in the first year, and in fact that’s what you’ll make every year if you decide to take out your interest as profits at the end of each year (this is known as simple interest). So in ten years’ time you could make £1,000 in interest from your initial £1,000 of capital. You’ve doubled your money. Nice.
However, let’s say that instead of taking out the interest each year, you reinvest it back into the account. This is known as compounding. After the first year you’ll have £1,000 (your capital) plus £100 (your interest). But after the second year you’ll have £1,100 (your capital) plus £110 (10% interest on £1,100). After the third year you’ll have £1,210 (your capital) plus £121 (10% interest on £1,210). And so it goes on. This time you’ll double your money in just over 7 years instead of 10. That’s even nicer.
For the sake of simplicity I’ve ignored the effects of inflation and tax on these calculations. They’ll reduce the actual ‘profit’ each year, but they don’t change the outcome, namely that compound interest will make your money grow much faster than it otherwise would.
The effect of compounding is one reason why pensions advisers recommend that you start a personal pension plan as soon as you can (the other reason being that they want their commission). Each year of profits reinvested greatly improves the chances of you having a decent pot at the end of your working life with which to buy annuities, assuming the government of the day hasn’t raided it, of course.
We’ve shown that compounding can be pretty impressive over a ten-year period, but pension plans typically run for much longer, often throughout your entire working life. It’s in this sort of situation that the power of compounding really makes itself felt. Again, we need an example, this time in the form of a table.
Here we have two people, Tim and Bob, both aged 20. Tim is the cautious sort, always putting a bit of cash aside for a rainy day, while Bob tends to be less careful with his money, preferring to spend it all on having fun rather than putting it into savings. Regardless of which of these attitudes is philosophically sensible, we can see from the table whose attitude is likely to pay off financially in the long term.
Tim starts paying £1,000 into a savings account each year from the age of 20 (maybe using an ISA or a pension plan or something similar). We’ve assumed an interest rate of 5% for this example, so each £1,000 that Tim pays in will generate £50 of interest per year, which he then reinvests back into the account, i.e. he’s compounding the interest. Tim does this for 10 years, then stops paying money in, perhaps deciding that after being rather boring in his 20s, he really ought to get out there and live a little before he gets too old.
Bob, meanwhile, has blown most of his earnings on expensive wine, fast cars, unwise property deals and the sort of women your mother warned you about. Reaching the end of his 20s and feeling rather haggard, Bob decides that he too should start saving for his dotage. From the age of 30 he starts to put away £1,000 per year, also making 5% per year. He is also compounding the interest.
But a strange thing happens. Even though Tim stopped paying in money once he reached 30, Tim’s pot continues to grow thanks to the power of compound interest. After ten years of paying money in, when they’re both 40, the value of Bob’s pot is still only about 60% of Tim’s. In fact it takes Bob a total of 20 years of contributions to finally build his pot up to the same size as Tim’s, and he’s paid in a total of £20,000 to do so rather than Tim’s total outlay of £10,000.
This is the true power of compounding: the earlier you start saving, the faster your savings will grow. Once you understand this, you’ll be in a much better position to make the most of your money.
And what of the other type of people, the type that is doomed to pay compound interest? These are the people who miss payments on their credit cards, stray into unauthorised overdrafts, forget to pay bills and generally have less of a grip on money matters.
The payments they miss are added to their outstanding balance, along with often punitive fines and interest charges. They start paying compound interest instead of earning it. Many such people don’t realise it, but they could end up paying twice as much as they would have done if they hadn’t bought on credit in the first place. Once you stray into such debt, it is in the lender’s interest to keep you there (pun intended), and they will milk you like a cow.
It’s never too late to start making the power of compounding work for you, but as we’ve shown here, the earlier you start, the better.