You remember in maths where you had to learn about compound interest and it was really dull and you didn’t care anyway? OK, maybe that was just us but try and imagine anyway. Now if they had put it in terms of pounds and pence, showing you how compound interest makes you money with no effort on your part, we would have listened! So, if you’re like us and really not that fussed about maths but quite interested actually in making money without effort, here’s the lowdown on compound interest. Concentrate at the back!
- How compound interest makes your investments grow
- Here’s how compound interest works
- The first law of compound returns: start early!
- The second law of compound returns is: small differences in the rate of return matter. A lot!
Simply put, investing involves turning money into more money – without you having to work at it. It’s making money while you sleep – nice concept!
How does this money turn into more money? Through compound returns – i.e. the miracle of compound interest.
It works by adding interest on your interest. When you’re in debt it’s your worst enemy, but when you’re investing it’s your best friend.
It’s like snowballs!
Go to the top of a mountain in Gstaad in the middle of winter, make a snowball in your hands and roll it down the hill. As the snowball rolls down it picks up snow as it goes. Every revolution is bigger than the one before. At the bottom you’ve got yourself a snowball the size of a hot air balloon. (It’s a really high mountain, okay?)
Compound interest works like a snowball. You put money into something that gives you interest or other returns each year and it grows by a greater amount annually.
Think of putting £100 into something that gives you a 10% return (wow) each year. After a year you’ll make £10. If you keep that extra in the fund at the end of the next year you’ll make £11 (10% of £110). At the end of the next year you’ll make £12.10 (10% of £121) and so on. Each year you make more than the last. Nice!
1. The more you save and the longer you save for, 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. Over a long time it really adds up.
2. Small differences in the interest rate can make a big difference in the long term so try to go for the biggest return possible on long-term investments. Also cut out tax where possible.
Let’s say your granny decides to give you £1,000 on your birthday. (Well, she always was your favourite granny). You decide that instead of blowing it on a new wardrobe down at Gap, you’re going to invest it in a simple index-tracking ISA.
For the purposes of our example, let’s say your £1,000 appreciates at a rate of 12% a year (before taking account of inflation) – a not unreasonable estimate right now. After five years, the numbers should look like this:
- Year 1 – £1,120
- Year 2 – £1,254
- Year 3 – £1,405
- Year 4 – £1,574
- Year 5 – £1,762
So without doing anything at all, you’ve just made yourself a profit of £762! If you’d spent your £1,000 down at Primark, where would your ‘investment’ be now?
Now let’s introduce you to Kylie, a young woman who, on her 20th birthday, decides to invest £100 a month into an index-tracking ISA. At the age of 30 she marries Wayne, stops work to have children and cancels her direct debit into her ISA.
Wayne, meanwhile, who has frittered away his money and his twenties on pastimes too terrible to mention here, decides on his 30th birthday to start contributing the same £100 a month into the same scheme and continues until he is 60. The numbers pan out like this:
- Age 20 £0 £0
- Age 30 £22,404 £0
- Age 40 £69,582 £22,404
- Age 50 £216,112 £91,986
- Age 60 £671,210 £308,097
Ouch! Extraordinary, isn’t it? Kylie only contributed for 10 years and yet she’s ended up with more than twice as much as her husband. Not only that, overall Kylie contributed a total of £12,000 while Wayne paid in £36,000 – three times as much for only half the return!
Real wealth, the stuff of dreams, is not created overnight. It is, in fact, created almost magically through the most mundane and commonplace of principles: time and the power of compounding.
Let’s look at yet another example. Assume a number of women at the age of 20. All appreciate the importance of long-term regular investment but disagree about the best method. For the sake of argument we’ll assume that they have each chosen methods that return different annual growth rates and they each contribute £100 per month until they’re 60.
Let’s look at the numbers:
Fennella Felicity Ffyona
5% 8% 10%
- Age 20 £0 £0 £0
- Age 30 £15,499 £18,128 £20,146
- Age 40 £40,746 £57,266 £72,399
- Age 50 £81,870 £141,761 £207,929
- Age 60 £148,856 £324,180 £559,461
Frances Freda Faith
12% 15% 20%
- Age 20 £0 £0 £0
- Age 30 £22,404 £26,302 £34,431
- Age 40 £91,986 £132,707 £247,619
- Age 50 £308,097 £563,177 £1,567,625
- Age 60 £979,307 £2,304,667 £9,740,753
Take a look at the bottom line for each woman. It speaks for itself, doesn’t it? Over long periods of time a difference of only one or two percentage points can have a huge impact.
It’s obvious that the type of investment you put your money into has a big influence on the return on investment but there’s another thing that needs to be taken into consideration. Any ideas? No? Give up? Oh, all right then – charges!
Give yourself a pat on the back and treat yourself to a HobNob if you got it right.
Imagine Frances with her 12% growth rate is actually investing in a fund that has annual maintenance charges of 2%. She hasn’t thought about it much but, each time her investment fund takes its cut, her cash pile reduces. By the time she’s 60 she’ll only have the same as Ffyona – little more than half as much as she would have accumulated without the charges.
The same goes for initial charges. Imagine Freda with her 15% rate of growth is paying initial charges of 5%, reducing her monthly input to £95. That extra £5 could have added about £100,000 to her fund over the 40-year period if she’d been able to invest it.
Charges of any kind are extremely painful. Annual maintenance charges of much above 1% and initial charges, which can be as high as 6% for some unit trusts, are quite simply, excruciating. So the third law of compound returns is: watch the charges!