What is Compound Interest?
It's known as one of the eight wonders of the world. But what is it and what does it mean for your investments?
Warren Buffet once said “My wealth has come from a combination of living in America, some lucky genes and compound interest”. So the magic of compound interest is not to be underestimated when it comes to your investments as it is what helps them to really flourish in the long-term.
So, what is compound interest and how does it work? We're here to break it all down for you.
How does compound interest work?
Compound interest means that each time interest is paid into an amount saved, the added interest also receives interest. Basically, interest on interest! This is one of the reasons many investors are so successful. But this all sounds quite theoretical and not quite so real, it’s an explanation that can take a bit of reading!
Let's break it down into steps…
Firstly, you deposit money, and the bank pays you interest on your deposit (when looking for somewhere to deposit your money, compare interest rates. Find the best rate available)!
Fast forward a year, this is where the compound interest comes in. You will earn interest on your initial deposit, and you’ll earn interest on the interest you just earned. The interest your money earns in the second year, will be more than the first year, as the balance has increased. Your interest could be added daily, monthly, or yearly. This same effect could also be seen if you invest and receive an income from dividends.
Compound interest is kind of like the ‘snowball effect’. A snowball starts small, however as more snow is added, it gets bigger. As it grows, it becomes bigger at a faster rate.
Compound interest formula
For the mathsy minded amongst us, it might really help to have a formula to better understand how this all works. If the days of algebra send your head spinning and you’d prefer to stick with words and sentences, skip over this next bit of formula and explanation.
T = S (1 + [g / f]) * fy
- T = total amount of money that's grown from compounding
- S = starting amount of money that you invested
- g= the growth rate or annual rate of interest
- f = frequency of which the compounding is calculated
- y = the amount of years that the investment will be held for
Let's look at an example of compound interest
You invest £1,000 and where you have decided to invest has an interest or growth rate of 5%. This means that every year (or day, or month!) 5% of what you have invested, will be added to your investment. At the end of the first year, you receive interest of £50, which is added to your investment. For the second year, the amount of interest you receive is based on £1,050. At the end of your second year, you receive interest of £52.50, again this is added to your investment. For the third year, the amount of interest you receive is based on £1,102.50. At the end of the third year, you receive interest of £55.12, which will be added to your investment. Over time this then starts to take off and grow, you get the picture!
As we just mentioned, this also applies to dividends. If you reinvest dividends, you can maximise your long-term returns because of the power of compounding. By reinvesting your dividends you buy more shares, which increases your dividend the next time, which lets you buy even more shares, and so on.
Compound interest really is amazing. It allows potentially quite small amounts of money to grow into large amounts over time. However, to see this growth and take full advantage of the full power of compound interest, investments must be able to grow for the long term. If you invest £1,000 tomorrow, then £1,000 a year for 30 years, with an interest rate of 3%, in 30 years’ time you could have a pot of £51,810.98. That’s £20,810.98 earned in interest!
Using compounding logic, if your money is growing at 7%, it takes only 10 years to double your money thanks to compounding. These are pretty hefty numbers and not something to be missed out on.
How is compound interest different to simple interest?
Most of us have heard of the concept of interest by simply having a bank account. This idea is a little different to compound interest however and is known as simple interest. When put into formulas and calculations, simple interest is quite simply the calculation of the interest earned, multiplied by the amount of time that the investment is held for. So if you had £1,000 and it was growing at a 4% rate for 10 years, you’d very simply multiply £1000 X 1.04 to get the interest earned and you’d then multiply that by 10 years, to reflect the amount of years that the investment was going to be held for.
It shows how much interest could be earned if all growth was essentially withdrawn. In reality, it is very rarely used when calculating investment growth, as it doesn’t show the true potential of investments growing with the effects of compound interest. In a nutshell, the calculation for compound interest takes into account the total amount after the growth has been added on, whereas simple interest overlooks this.
Monthly or yearly compounding
The frequency of the compounding affects how much gravity the compound interest has and how quickly the investment can start to take off. Most calculations are done either monthly or yearly, but they can also be quarterly, bi-annually or even daily. This will depend on how frequently income or growth is paid. If the compound interest is calculated monthly rather than yearly, it’s likely to grow with greater speed.
The importance of investing in relation to compound interest
Compound interest is a magical theory and really shows the power of buying and holding investments for the long term. Those that can benefit from compound interest the most are those who are prepared and able to hold their investments for the longest period of time.
ISAs and Pensions are two places where compound interest can also really flourish, as they help protect investments from the burdens of taxation on growth. When investments are protected from erosion, compound interest can really start to snowball the value of your investments.
It is worth pointing out that compound interest can also work against you negatively. When you borrow, you will pay a rate of interest in exchange for the money that you’ve been lent. The more debt that you accumulate, the more you’ll need to pay back in interest. If you’ve got high interest debts, prioritising these is a must, as compound interest can cause these to quickly spiral out of control, in the wrong way.
Investments that help compound interest
The truth is that compound interest works best when there is growth in investments. Any investment that grows, or generates an income that is reinvested, can benefit from compound interest. Generally, the longer you’re willing to hold an investment for, the more you will benefit from compound interest. Stocks, funds and ETFs that generate a dividend that can be reinvested can all benefit from compound interest, as can bonds, interest paying bank accounts (albeit very low amounts) and REITs (Real Estate Investment Trusts- a type of income generating property fund).
The bottom line
Compound interest gives your money and investments a rocket boost over the long term. When used in conjunction with goals that are potentially many years away like retirement, you can put an awful lot less of your money towards saving and let compound interest work its magic. The more you reinvest and the higher the rate of interest or growth, the more you’ll improve your chances of compounding AKA growing your investments.