In a nutshell:
Compound interest is a powerful concept to build wealth over time. You are able to earn interest on interest, producing exponential increases in wealth over time.
- Compound interest is ‘interest on interest’
- The earlier you start investing the better to take advantage of compound interest
- What is Compound Interest?
- The Importance of Starting Early
- Best way to utilise Compound Interest
What is Compound Interest?
The power of ‘compound interest’ is best illustrated through examples. Simply put, all it means is earning interest on interest, and we are able to use it to ‘compound’, or increase, our wealth over time.
Lets say you invest £1,000 into the stock market, and you are able to earn 10% interest, each year, for three years. This is how your wealth would increase:
Year 0: £1,000
Year 1: £1,100
Year 2: £1,210
Year 3: £1,331
The reason for the exponential increase, or the increases in wealth becoming larger and larger, is because we are earning interest on top of the previous years’ interest. The graph above shows the effect of compound interest. It is important not to touch your principal!
The Importance of Starting Early
Compound interest is more effective the earlier that you start investing. This is because your money can earn a return for more years, and earn a return on previous returns, resulting in more money in the end.
Once again, lets go through some examples of investing £1,000 initially, and then earning 10% interest per year over a 10 year, 20 year and 30 year timeframe.
10 years: £2,707.04
20 years: £7,238.07
30 years: £19,837.40
As you can see, the longer time frame the more your wealth will increase exponentially! Particularly if you are younger, in your 20s, it is important to take advantage of the time you have and begin compounding your wealth – rather than putting off investing until you are older.
However, so far, we still haven’t even considered ‘topping up’ our investment, by investing monthly on top of the initial investment…
Best way to utilise Compound Interest
The best way is to invest monthly. Lets go through another example:
For the final time, assume we invest £1,000 initially, earn 10% interest per year, but now we will ALSO invest £100 per month:
10 years: £23,362.24
20 years: £83,897.76
30 years: £247, 769.93
With compound interest AND monthly contributions, investing say into an index fund, you are able to drastically increase your wealth – just imagine if you are able to pay in £200 a month or even £1,000 a month? Or start with a larger initial lump sum of £10,000? Or invest for 50 years?
Just for fun let’s say you initially start with a £10,000 investment, you make a more moderate 7% return per year, but are able to contribute £750 per month. After 30 years you would have £1 million!
Although – it is important to point out that we have made many assumptions with these calculations. Whilst the market historically has returned 7-10% per year, there will also be downturns and recessions – this is why it is important to invest for the long term and stick to your plan of investing £X per month.
If you would like to experiment with some numbers based on your own circumstances, or just for fun, go here: https://www.thecalculatorsite.com/finance/calculators/compoundinterestcalculator.php.
That’s the power on compound interest.