Compound interest is a fascinating topic, and understanding what it is and how it works can hugely improve your life. Albert Einstein is quoted as saying compounding interest is “the eighth wonder of the world”. That’s why today I’m going to try to explain what it is in the simplest terms possible, so that even your kids can understand its power.
Compound Interest Explained
Compound interest can be thought of as snowballing of money.
Imagine you have £100.
You got a 5% return on this money in an investment last year. You now have £105.
You get another return of 5% on your investment the following year. How much do you now have?
- a) £110
- b) £110.25
If you answered b, congratulations – you understand compound interest. This is because you earned 5% on your initial £100, but also 5% on the money gained from the first year of interest.
So Why Is Compound Interest So Important?
Compound interest becomes extremely powerful over a longer period of time. Here’s an example.
You have £10,000. After doing some research, you found a very good investment opportunity, which returns 1% per month on average.
After 1 year of holding this investment, your £10,000 has turned into £11,268. After 10 years, your £10,000 has snowballed into £33,003.87. That’s right, just 1% per month for 10 years more than triples your money. If you’re able to live below your means, every single spare pound can multiply over the course of your life, and can be used to make retirement actually possible.
So, how can we apply this to investing and become wealthy in the process?
How To Use Compound Interest To Make Money
Please note, I am absolutely not a financial advisor and this is purely for the sake of argument. Do your own research and pick investments based on your own personal needs and data.
Over the last several decades, the S&P500 has returned over 8% on average per year. Lets use 6% as a conservative annual gain you can realistically attain from a range of different investments.
In the UK, we are currently able to deposit £20,000 in a given tax year into a stocks and shares ISA.
Let’s say you start paying in when you are 25, and plan on retiring at 65, around the average age. I’ve made a table below showing a rough estimate of how much your ISA could be worth, depending on how much you invest into it per month up until retirement age:
| Monthly Investment | Low (4% per year) | Medium (6% per year) | High (9% per year) | Warren Buffett (19.8% per year) |
| £100 | £118,690 | £200,244.82 | £351,528.12 | £15,885,526 |
| £250 | £296,725 | £500,612 | £1,179,357 | £39,713,815 |
| £500 | £593,450 | £1,001,224 | £2,358,715 | £79,427,631 |
| £750 | £890,175 | £1,501,836 | £3,538,072 | £119,141,446 |
| £1000 | £1,186,901 | £2,002,448 | £4,717,430 | £158,855,262 |
| £1250 | £1,483,626 | £2,503,060 | £5,896,787 | £198,569,078 |
| £1500 | £1,780,351 | £3,003,672 | £7,076,145 | £238,282,893 |
| £1666.67 (maximum) | £1,978,172 | £3,337,420 | £7,862,399 | £264,759,300 |
How To Make Compound Interest Work In Your Favour
When we take a look across the table above, there are three main ways to hugely improve your returns – time, return, and amount invested.
The difference over your working career between investing £500 per month and £750 per month (based on a conservative 6% annual return), you will end up with £500,000 more. That’s a huge difference.
Time is another big factor.
If you invest £500 per month, returning 6%, for 25 years, you will make £198,000 or so in interest.
On the other hand, if you hold on for just a single additional year, you will earn over £20,000 extra, just from the interest.
How Compound Interest Works Against You
Compounding interest can also work against you with certain forms of Debt. Student loans, mortgages, and a lot of other loans have interest which can compound over time. This is why when you borrow £100,000 on a mortgage at say 4%, you repay a whole lot more than £104,000.
To make sure you can minimise the impact of compounding interest working against you, it’s absolute essential to work hard on reducing the negative effects of compound interest. If you’re able to, it might be worth looking into overpaying your mortgage to reduce the amount of interest you end up paying. Martin’s Money Saving has a great calculator to work out how much you can save by overpaying here.
Conclusion – Compound Interest Really Is The Eighth Wonder of the World
Understanding the power of compounding interest is absolutely essential when it comes to making your money work from you. Especially when working a normal 9-5, there’s only so much work you can physically do to make money, so making your money work for you is incredibly important. Speaking of making more money, I’ve covered 15 ways of earning some good money which are easily manageable alongside your job over here.