The great Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it…..he who doesn’t…..pays it.”
So what is compound interest? It is essentially earning interest on your interest which occurs when you constantly re-invest interest or dividends from your investments. It enables you to grow your money by significantly more than you would have done if you had simply taken the income and spent it.
Simple interest on the other hand is where you earn interest on the original capital only. So if you invest £100 and earn 7% you receive £7 a year. If it were compound interest you would earn £7 in the first year then £7.49 (£107 x 7%) in the second year and so on. After 10 years you would have earned £70 interest under simple interest and about £100 using compound interest.
A simple rule of thumb you can use for how long it takes to double your money using compound interest is the rule of 72. You simply divide the interest rate, say 7, into 72 and the result is 10 (years).
Let me give you some examples of compound interest.
Two savers each invest £2,500 a year into pensions. The investment growth is 7% a year. The first investor started saving at age 21 and stopped at 30. All income and gains were re-invested into the pension which continued to grow at a rate of 7% a year. The second investor started saving at age 31 and stopped at age 70. Who do you think ended up with the largest pension?
The second saver’s pension grew to £534,000 but this was trumped by the first saver whose pension grew to £553,000! What’s more the first investor saved just £25,000 whereas the second investor saved £100,000. This means that the first saver’s investment grew by a factor of 22 whereas the second investor’s investment grew fivefold.
So a 10 years saving strategy gave a bigger pension than a 40 years one. Remarkable isn’t it?
An even more amazing example is that of a parent who invests into a pension scheme for a new-born child. A parent saves £2,880 a year into a pension for a child for just 2 years. Tax relief of £720 is immediately claimed back from HMRC which means that the £2,880 is grossed up to £3,600 straight away. Again assuming an investment return of 7% a year the pension fund will grow to £551,000 by the age of 70.
So if you would like advice on how to make your investments grow by using compound interest why not get in touch with me? You know it makes sense.