Compound interest is what makes your money grow when you invest it in building society accounts or shares. It’s also what makes your debts grow if you don’t pay them off fast. The principle of compounding works like a snowball.

• Your initial ball of capital (the money you’ve put in) collects interest (a percentage paid back to you for the loan of the money) over a year.

• If you keep it there that means that your original capital has grown a little by the end of the year.

• That means that in the next year you earn interest on a larger sum so the interest you receive is slightly greater. And so it goes on each year with the amount on which you are earning interest growing exponentially (rolling faster and faster down the hill to grow more rapidly in size) every twelve months.

The more you save and the longer you save, the more you’ll end up with. You start off just getting interest, but then you earn interest on that interest and then you earn interest on the interest on the interest, and so on.

The two things that create wealth for you are:

• The level of interest you’re getting (big numbers are better than small here, so a 10% return is going to make you much richer than a 5% return), and

• The length of time you keep the money in an investment. Over long time scales, with compound interest working its magic, it all really adds up.

In the case of shares this is why it’s important to re-invest the dividends you receive from your shares each year. If you buy more shares with your dividends then that’s more shares you have the next year to produce more dividends with which you can then buy more shares and so on and so on until you’re so rich Bill Gates is calling for a loan.

If you want to see the joy of compound interest before your very own eyes, trying plugging some of your investments (or anticipated investments) into this compound interest calculator.

How compound interest works:

Compound interest is basically making interest on your interest.

It’s like a snowball. Imagine a small pebble at the top of a snowy mountain. As it rolls down the mountain it gathers snow on each roll. This makes it bigger every time it turns as each revolution gathers more snow. That’s how compound interest works. For example:

1. Say Vic starts off with £1000 and he’s earning 10% a year on his investment. If he keeps what he’s earned each year in interest in that investment, it will grow at a bigger rate each year.

Year 1       10% interest on £1000 = £100

Year 2       10% interest on £1100 = £110

Year 3       10% interest on £1210 = £121

Year 4       10% interest on £1331 = £133

Year 8       10% interest on £1946 = £195

Year 9       10% interest on £2144 ……

After 8 years Vic has more than doubled his money.
Small differences in the interest you get each year make a big difference in the long term. So even a real rate of ‘just’ 8% (around 4% more than what you can earn in an average bank savings account) can produce a large sum if you give it enough time.

Using the figures from the example above:

2. If Vic put his money into an average bank savings account:

Year 1       4% interest on £1000 = £40
……
Year 9       4% interest on £1369
By year 9, all other things staying the same, Vic has earned £369 from his bank account.

3. But, if Vic put his original nest egg into an investment paying 8%.

Year 1       8% interest on £1000 = £80
……
Year 9       8% interest on £1851

So he’s earned £851 in interest, £482 more than if he kept it in the average earning account.