What is Compound Interest?

The Investment Board: Compound interest can help to supersize your savings over the long-term, but how does it work? We do the maths

Holly Black 13 March, 2020 | 10:55AM

 

 

Holly Black: Welcome to the Morningstar Investment Board. I'm Holly Black. Today, we're going to talk about compound interest. This is one of those horrible jargony words that gets thrown around a lot, but it is quite an important one to know about. Unfortunately, the official definition that's usually given by investment folk is, this is the interest you earn on your interest, on your interest, which doesn't mean a whole lot to anyone. Or if you're really unlucky, someone might show you this formula, at which point, you probably just start crying. Other people say that compound interest is the eighth wonder of the world. And I would argue that those people had probably never been to these places, each to his own.

So, what is compound interest? It is the way your money grows over time, and the fact that the longer you leave it saved or invested, the more it will grow. So, I've got an example to show this. Let's imagine that we save £1,000 and we get interest of 5%. I'm not sure where we're getting this because that's obviously a magic savings account that doesn't exist, but it does make my sums easier. So, after a year we will earn £50 in interest because that is 5% on 1,000. And that means our pot is now worth £1,050. Now, this is where compound interest kicks in. If I leave this invested for another year, and it also grows at 5%, the amount of interest I'll earn in the second year is £52.50. So, I've not invested a single penny more of my own money, but because my initial pot is now bigger because I kept this interest, the interest the second year is bigger. So, now I've got £1,102.50.

Now, this starts to get really interesting when you start to look at the numbers over the long term. So, let's fast forward to 10 years. At this point, I will £77.57 of interest in a year, and my pot is now worth about 1,628 quid. There are a few pennies involved in a lot of these, but my whiteboard is not long enough. And I've still not invested a single penny more. And if we go even further into the future, at 30 years, I will earn £205 of interest just in that year, because of the way this is building up and my pot is now worth £4,321.

So, you can see that over time, it just means your money can grow and grow, and the interest sums every year get bigger because the pot is getting bigger. And where this starts to get very interesting is pensions. This is the way that most people will interact with compound interest in their life. Because as well as the very long time that you're investing in a pension, you'll probably start in your mid 20s now, and you're not going to retire till you're mid-60s, and you're also going to add money to that pot every year. And that means these gains start to get supersized.

So, let's start to think about pensions. So, we'll start with £1,000 and it grows at 5%. So, in our second year, we've got £1,050. But I'm also through pension contributions going to add another £1,000 into the pot. So, that actually means in the second year, I'm investing £2,050. So, if that also grows at 5%, rather than the £50 of interest I get in the first year, I'm going to get £102 of interest and my pot will be worth £2,152. So, I've invested £1,000 of my own, enjoyed the interest and added another £1,000 into the mix.

Now, if we take this super long term, this gets really good. So, after 10 years, we're going to be earning £628-ish of interest, and the pot is now worth £13,206. Now, of that remember, I'm putting £1,000 every year. So, £10,000 of that is money I've saved, £3,000 is just from interest. And after 40 years, this is genuinely how long you're probably going to be saving into a pension for, the amount of interest I earn in a single year is £6,040, and I head off into retirement with £126,842 pounds. I've been saving 40 years. Only £40,000 of that is actual money that I've put in. And if that all starts to feel quite intimidating, remember that with a pension, most likely your workplace, your employer is going to be putting money in too. So, this isn't all out of your own pocket. £1,000 a year might sound like a lot to set aside. It's not that bad. It's £83 a month. I've worked that out to be about 30 coffees or something else you can think of that costs about £2.70 a day.

And that's compound interest.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Holly Black  is Senior Editor, Morningstar.co.uk

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