'Compound interest' is a phrase that is regularly used in the world of savings andinvestments andalthough its meaning may not be immediately obvious, it’s actually quite easy to understandand can havea significant effect on yourfinances. This relativelysimple concept is relevant to both your savingsand debts, and as such it is something anyone planning their financial future should lookinto.
What is compound interest?
Compound interest refers to the principle that when you save money, as well as earninginterest on thesavings, you also earn interest on the interest itself. Therefore, every year that the moneyis in youraccount you are earning interest on each previous year’s interest. This means that not onlyare yoursavingsgrowing over time, but that the rate at which they grow gets faster as well.
We can see this in action by taking some basic figures – for example, if you deposited £1000at a rate of10%, at the end of year one you would have £1100, equalling £100 of interest earned. Thefollowing yearyouwould earn £110 in interest – 10% of the original capital and 10% of the year one interest.The nextyearwould be £121 and so on.
The rate at which compound interest (or ‘compounding’ as it is sometimes known) accumulatesalso dependsonthe frequency of interest payments. If the interest period is not annual, but is insteadbi-annual orquarterly or monthly, then the total amount of interest paid across the year will be higher.This isbecauseinterest is being paid on interest accumulated in those smaller periods.
Why compound interest is powerful
The concept of compound interest is powerful because even if you do not add to your savings,they cancontinue to grow. Over a long period, this can create a huge difference and explains why,when it comesto savings advice, so many experts will tell you to start saving early.
If an individual was to start saving £100 a month at the age of 30 and continued until theywere 60, theywould have saved, with 10% annual interest, a sum of £217,132.11. However, if they startedsaving £100 amonth at the age of 20, stopped when they were 30 and left the money in the account untilthey turned60,they would have accumulated £367,090.06 The ‘magic’ of compound interest, in this example,means thatsavingfor 10 years can be more profitable than 30 years, if it starts earlier.
Although the example above is quite a simple hypothetical one, which you can replicateyourself by usingacompound interest calculator or spreadsheet; real life cases can potentially see a similareffect. Inreality there are other factors such as inflation, fluctuations in interest rates andwithdrawals/deposits, which will affect how your savings grow.
How compound interest works with credit cards
Although compound interest can provide huge benefits for savers, the concept also applies tointerestpaid on debt. When you make repayments on a credit card you will be paying back interest onthe originaldebt, but also on the interest that is accrued. In the same way that a small amount ofsavings can growover time without additional deposits, a small debt can also grow without any furtherexpenditure.
The concept of compound interest is not that complex, but it is possible to underestimatejust how bigits effect can be. This may be a pleasant surprise when your savings grow faster thanexpected, butcould mean that people taking on debt do not realise the total amount they will have to payback, ifmaking small repayments over many years.
This is why it is important that before taking on debts, you fully understand how theinterest repaymentswork and are clear on different types ofinterest rate.
Calculating compound interest
The formula for calculating compound interest is 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 themoney isinvestedand ‘P’ is the final value of your savings. If you are not that familiar with equations, youdo not needtoworry about trying to plug in all the numbers yourself, as several tools exist online thatcan do it foryou.
One tool that was linked to above is from The Calculator Site - which cancalculatecompound interestpaidon regular deposits or on a lump sum. These kinds of tools are useful for giving anindication of whatmighthappen to your savings and may help you decide how much you need to save and how often.
