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Compound interest explained

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What do you think the most powerful force on earth is? Love? Hope? Um… capitalism? Well, according to Einstein (and he should know) it’s the impact of compound interest. He even described it as the ‘eighth wonder of the world. What is it?

What is compound interest?

You earn compound interest on your savings when the original amount (capital) earns interest, then the original amount plus interest earns interest and so on.

As an example, if you paid £100 into a savings account earning 3% interest (and we’ll assume it’s tax free):

  • After one year you’d have £103 (£100 plus £3 interest)
  • After ten years you’d have £134
  • After 20 years you’d have £180 (even though 20 x £3 interest is £60, you’d have earned interest on the interest.

OK, so an example using a £100 isn’t very impressive. Let’s look at something a bit more realistic.

Say you saved £100 a month in the same account paying 3% interest tax free.

  • After one year you’d have £1,216
  • After five years you’d have £6,458
  • After ten years you’d have £13,944
  • After 20 years you’d have £32,685

SAVVY TIP: In each case, the amount you’d get is more than the previous balance multiplied by the years you’ve been saving. So, £1,216 x 5 = £6,080, but if you save for five years you get £6,458 because of the effect of earning interest on interest.

Why does this matter?

The reason it’s important is that it shows how effective it is to start saving or investing earlier rather than later. That’s because the longer you save the bigger the impact of compound interest.

So, to give you an example:

  • If you start to save £100 a month at the age of 35 and carry on saving £100 a month until you are 65, you’ll have £57,871, assuming a 3% rate of interest on your savings throughout and that it’s tax free.
  • If you start to save £100 a month from the age of 45 until you’re 65, you’d only have £32,685.
  • If you wanted to get £57,870 and you started saving at 55 you’d have to save £178 a month (assuming you had the money in a tax free account).

Start saving early

Now, here’s the clever bit. Say you wanted to save £50,000 for your retirement (we’ll assume it’s in a savings account for now for simplicity).

I’ll also assume it will be in a tax-free account earning 3% and that you want to retire at 65. There are several ways you could reach your £50,000 goal through regular saving. For example, you could:

  1. Start saving £55 a month at the age of 25
  2. Start saving £87 a month at the age of 35
  3. Start saving £153 a month at the age of 45
  4. Start saving £359 a month at the age of 55

Alternatively, you could start saving something like £100 a month between the ages of 30 and 50. This will give you a lump sum of £32,685. If you leave that money where it is, by the time you’re 65 it will have grown to £50,922.

That means you only have to save £100 a month for 20 years. You don’t have to add another penny as long as you leave the money you’ve saved where it is.

Contrast that with the amount you’d get if you didn’t start saving until you were 45 (which would give you 20 years in which to save until you reached your 65th birthday), you’d have to save £153 every month.
So, you can take advantage of the power of compound interest and save £100 a month for 20 years if you start at the age of 30, or you can play ‘catch up’ if you start at 45 as you’d have to pay in £153 a month for 20 years.
Which would you prefer?

Related articles:

Saving with a peer-to-peer lender; are peer-to-peer savings safe?

How much can you save in a cash ISA and when can you transfer a cash ISA?

10 things you need to know about the Financial Services Compensation Scheme

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