Early maths lesson that could make you tens of thousands
is said to have described compound interest as the eighth wonder of the world.
Adding: “He who understands it, earns it; he who doesn’t, pays it.”
The story may actually be apocryphal … but it makes for more than just a nice line because it underlies the basics of savings and debt.
Compounding means that the returns on investments themselves become part of the investments and start generating returns.
In time, investments start generating disproportionately higher amounts, which makes a long-term strategy especially rewarding.
At its most simplest it can be construed as interest on interest – the so-called “miracle of compounding”.
At the more complex, it comes as a mathematical formula and you can work it out yourself:
P = C (1 + r/n)nt
Where ‘C’ is the initial deposit, ‘r’ is the interest rate, ‘n’ is how frequently interest is paid, ‘t’ is how many years the money is invested and ‘P’ is the final value of your savings. Tools exist online that can do the calculation for you.
The best way to take advantage of compounding is to start saving and investing wisely as early as possible.
Value Research explains: “As your returns start earning, and then the returns on those returns start earning, the profits start piling up.
“Starting to save at the age of 30 instead of 50 can mean retiring with four times the wealth. The earlier you start investing, the greater will be the power of compounding. If one has time to learn just one thing about investing, then this should be it.”
In similar vein, Equifax offers a hypothetical example: “If an individual was to start saving £100 a month at the age of 30 and continued until they were 60, they would have saved, with ten per cent annual interest, a sum of £217,132.11. However, if they started saving £100 a month at the age of 20, stopped when they were 30 and left the money in the account until they turned 60, they would have accumulated £367,090.06. The ‘magic’ of compound interest means that saving for ten years can be more profitable than 30 years, if it starts earlier.
“Real life cases can potentially see a similar effect. In reality, other factors such as inflation, fluctuations in interest rates and withdrawals/ deposits will affect how your savings grow.”
Equifax goes on: “Although compound interest can provide huge benefits for savers, the concept also applies to interest paid on debt. When you make repayments on a credit card, you will be paying back interest on the original debt, but also on the interest that is accrued. In the same way that a small amount of savings can grow over time without additional deposits, a small debt can also grow without any further expenditure.
“The concept of compound interest is not that complex, but it is possible to underestimate just how big its effect can be.
“This may be a pleasant surprise when your savings grow faster than expected, but could mean that people taking on debt do not realise the total amount they will have to pay back, if making small repayments over many years.”
This is why experts will frequently say that if you are in a financial mess, then the first thing to get rid of is expensive credit card debt. Equally, on the other side of the coin, the advice to those struggling with the cost of living crisis is to avoid, if you can, stopping your pension contributions, because it means you are losing out on the compounding effect and may face a reduced income in retirement.