Not all interest is the same, and not everyone understands just how powerful interest can be. We all earn interest on our money. We all pay interest on debts. There are two broad types and to understand compound, we should first understand simple interest.

#### Simple Interest and Compound Interest?

Simple Interest is merely the interest paid on your initial investment (this is called the principal), year on year.

Say you invest £100 at annual interest of 7% for one year. Simple interest dictates that at the end of the year you would have £107. At the end of the second year you will have earned another 7% on your £100, and now you have £114.

Compound interest (or compounding interest) is interest calculated on the initial amount invested, and also the accumulated interest of previous periods of a deposit or loan.

However, on a compound interest plan, at the end of year two, you would have £114.49. This is because the 7% interest rate was applied to your principal and the profit from the first year.

So in the first year you made £7.00 in interest, but in the second year you made £7.49. This is because of interest earned on interest and that is essentially what compound interest is. We will get into why this is such a powerful thing a little later.

#### A word from the wise

Albert Einstein in reported to have called compound interest “the eighth wonder of the world”, adding that “He who understands it, earns it; he who doesn’t, pays it.”

It’s true that when you look at the power and potential of compound interest, it is startling just how much can be earned with a bit of time on your side. The more the time better, in fact, and the earlier you get started on investing with compound interest the better your returns are going to be, because it is the later years where you will experience the highest growth.

To understand the true greatness of compounding interest I want to present a few different examples.

#### 1. Reinvesting your interest versus interest on capital only.

Consider the example above of £100 principal.

Again, I’m keeping the numbers small to illustrate the point. The table below shows how much can be made over 30 years when the interest is reinvested each year.

Year | Year Interest | Total Interest | Balance |
---|---|---|---|

1 | £7.00 | £7.00 | £107.00 |

2 | £7.49 | £14.49 | £114.49 |

3 | £8.01 | £22.50 | £122.50 |

4 | £8.58 | £31.08 | £131.08 |

5 | £9.18 | £40.26 | £140.26 |

6 | £9.82 | £50.07 | £150.07 |

7 | £10.51 | £60.58 | £160.58 |

8 | £11.24 | £71.82 | £171.82 |

9 | £12.03 | £83.85 | £183.85 |

10 | £12.87 | £96.72 | £196.72 |

11 | £13.77 | £110.49 | £210.49 |

12 | £14.73 | £125.22 | £225.22 |

13 | £15.77 | £140.98 | £240.98 |

14 | £16.87 | £157.85 | £257.85 |

15 | £18.05 | £175.90 | £275.90 |

16 | £19.31 | £195.22 | £295.22 |

17 | £20.67 | £215.88 | £315.88 |

18 | £22.11 | £237.99 | £337.99 |

19 | £23.66 | £261.65 | £361.65 |

20 | £25.32 | £286.97 | £386.97 |

21 | £27.09 | £314.06 | £414.06 |

22 | £28.98 | £343.04 | £443.04 |

23 | £31.01 | £374.05 | £474.05 |

24 | £33.18 | £407.24 | £507.24 |

25 | £35.51 | £442.74 | £542.74 |

26 | £37.99 | £480.74 | £580.74 |

27 | £40.65 | £521.39 | £621.39 |

28 | £43.50 | £564.88 | £664.88 |

29 | £46.54 | £611.43 | £711.43 |

30 | £49.80 | £661.23 | £761.23 |

- After the first year, you earn £7.00 in interest.
- After year 10 – £12.87/year on interest instead of £7.00
- After year 20 – £25.32/year instead of £7.00
- At year 30 – just short of £50/year instead of £7.00

Finally, after 30 years you would have £761.23 in total instead of just £310. And this is all without adding any more of your hard earned money to the pot.

#### 2. Reap the benefits of early investing

Assuming we can achieve an average of 7% return every year… (stock markets have returned an average of around 10% growth over the last hundred years) **then someone who saves for 10 years can have more for retirement that someone who saves for 40 years**. This is absolutely true, but it depends on *when *you do your saving.

Imagine you can save £2500 per year for 10 years between the ages of 21 and 30, then by the age of 70 your pot would be worth over £550,000. Over half a million pounds for retirement. Just think about that. Let’s say that again… Save £25,000 over ten years, and then if you never save another penny again, your nest egg can turn into £550,000 – roughly around 22 times the value of your savings, simply by just… waiting!

Compare this to starting to save at 31. You would have to save £2500 per year for 40 years to get to a figure of around £530,000. This means saving a total of £100,000 right up to your retirement date aged 70 for growth of around 5 times your savings for a smaller amount.

#### 3. Truly staggering investment for kids

As a final example, I am a relatively new parent. My boy is one year old and I often find my mind wandering and thinking about what the future will hold for him. He is lucky enough to have had many people give him monetary gifts and of course, his mother and I try to save a little for him every month. If we were to stash away, for example, £5000 for him now, then when he comes to retire at 70, hopefully after a long and successful life, then there could be a massive £497,813.75 waiting for him (assuming the same 7% growth per year) without him ever having to save another penny in his life. Half a million quid for just… waiting!

#### In Summary

Start early. Please. Save something. It doesn’t matter how much. I have demonstrated that even small amounts, when left long enough can grow to crazy amounts. There is a great calculator you can try out here: https://matt-harris.net/lab/compound-interest/

Play with the calculator and see for yourself just how powerful your money and compound interest can be for your future.

As ever, any questions or thoughts please leave a comment below and I’ll do my best to get back to you.

Pingback: Investing for your children 2022 – Pretty Penny

Pingback: Trading212 ISA 2023 - 5 Reasons to get one now - Pretty Penny

Pingback: 3 Essential Money Tips for 2023 - Pretty Penny

Pingback: Investing is pointless without decent money - Pretty Penny

Pingback: InvestEngine Savings Plans - 3 things you must know - Pretty Penny