Compound Interest, The 8th Wonder Of The World!

Wikipedia describes compound interest as:

Compound interest arises when interest is added to the principal of a deposit or loan, so that, from that moment on, the interest that has been added also earns interest.

This addition of interest to the principal is called compounding.

A bank account, for example, may have its interest compounded every year: in this case, an account with $1000 initial principal and 20% interest per year would have a balance of $1200 at the end of the first year, $1440 at the end of the second year, and so on.

And it was Albert Einstein who said:

"Compound interest is the eighth wonder of the world.

He who understands it, earns it... he who doesn't... pays it."

Let's look at some numbers so we can see compound growth in action.

If I were to ask you which option you'd prefer, how would you (honestly) answer:

1. 1p that doubles every day for a month

2. £1m cash in your bank account immediately

Now, you may be thinking that this is obviously a leading question and you'd be correct! But I'm guessing if the question was asked out of the blue many would opt for 2.

In fact, option 1 would return in excess of £10m!

The power of compound interest at work.

I'll admit that it's unreasonable to expect a 100% return on any investment every single day, however it's the principle that I want to concentrate on.

In effect, all interest earned on any investment is effectively free money and interest earned on interest is the holy grail.

The 3 Rules

The amount of money you'll get back on any investment is determined by:

1. The amount you invest

2. The length of time your money is invested for

3. The rate your money grows at

Back to some numbers.

Let's say you have a target of £300,000 at age 60.

Age     Years to 60     Growth Rate     Monthly Payment     Total Invested 

30             30                      5%                        £366                 £131,760

40             20                      5%                        £736                 £176,640

50             10                      5%                        £1,936              £232,320

So as you can see, the longer you leave it the more it'll cost over the long term.

Looking at another example, let's say you invested the £366 per month between the ages of 30 and 40 but then stopped.

Here's how the numbers look:

Age.......................30..............40..........50

Years to 60............30..............20..........10

Growth Rate..........5%.............5%..........5%

Monthly Payment...£366..........£369........£971

Total Invested.......£43,920.....£88,560.....£116,520

Maturity Amount...£150,513....£150,513....£150,513

As you can see, the 'cost of delay' is stark, so if you can afford to invest more at an earlier age you'll save a hefty sum, all factors being equal.

So, time indeed can be your friend when investing.

Looking at rule 3, how do the numbers look if the return is 7% pa? (remember, the target is £300,000)

Age.......................30..............40...........50

Years to 60............30..............20...........10

Growth Rate..........7%.............7%..........7%

Monthly Payment...£255..........£588........£1744

Total Invested.......£91,800.....£141,120...£209,280

As you can see, there's not a huge saving if you start investing at 50 (10%), however it's a different story at age 30 where you'd save 30%!

And what about the cost of delay example at 7% pa where you invest the £255 per month between the ages of 30 and 40 but then stop?

Age.......................30..............40...........50

Years to 60............30..............20...........10

Growth Rate..........7%.............7%..........7%

Monthly Payment...£255...........£333........£987

Total Invested.......£30,600......£79,920....£118,440

Maturity Amount...£169,738.....£169,738..£169,738

You get the point, I'm sure.

Whilst there are a number of factors you should take into account before you invest, some of the key ones are (in no particular order):

- Inflation

- Investment fees

- Transaction fees

- Adviser fees (if you use one)

- Product fees

- Tax

Key Considerations

It's not always easy to invest the amounts you want when you have other commitments, however by budgeting and being more aware of where you're spending your money it's possible to find additional sums each month.

Action Point

If you do want to analyse where your money goes each month, the tool we recommend is You Need A Budget.

After all, if you're able to invest another £100-£200 each month you'll be able to (potentially) enjoy the benefits of the 8th wonder of the world!

at 8:07 PM
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