The Power of Compound Interest
On the topic of compound interest, Albert Einstein famously said, “Compound interest is the eighth wonder of the world. He who understands it earns it… He who doesn’t, pays it…”
Compound interest, in simple terms, allows you to earn interest on your 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 any previously accumulated interest.
Simple interest, like with a term deposit, is different. It usually pays the interest in one go at the end of a specified period. For example, if you invested £1000 for five years at 5%, with interest paid at the end of the term, you would receive £250 in simple interest (a total of £1250), or £50 for each year. (£1000 x 5% interest = £50 interest x 5 years = £250 interest total).
If you invested the same amount for five years at 5% with interest paid every year, you would earn £276.28 in compound interest after the five-year period, giving you a total of £1276.28
Returns are higher than the simple interest example because interest is paid on the interest.
The earlier you start a retirement plan or pension, the better. This is because the longer you are compounding your returns, the higher the benefits. By starting earlier, you have much more time to compound. Saving both early and often brings you the full power of compound interest. If you do start saving later, you’ll need to save much higher amounts to reach your objectives.
Look at these tables which show the power of compound interest – regular saving and lump sum investments.
In order to save £1 million by the age of 65 at 6% interest you would need to put this much aside each month:
|Age Started Saving||Monthly Saving||Growth|
When investing a lump sum here is another table showing the power of compound interest:
Lump Sum Investment
|Age Invested||Investment||Growth||Total at aged 65|
|30||100,000 GBP||6%||768,608 GBP|
|40||100,000 GBP||6%||429,187 GBP|
|50||100,000 GBP||6%||239,655 GBP|
|55||100,000 GBP||6%||179,084 GBP|
By contributing to your pension and investing over a long time-frame, you can expect to have much more than you originally contributed.