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What is compound interest?

Compound interest is one of the most powerful forces in financial planning. By enabling you to maximise your returns, it can help you reach your goals more quickly. So, what is compound interest and why does it have such a huge effect on investment portfolios?

What is interest?

Let’s start by defining the word interest.

Interest, generally, is a cost paid by either a borrower or a deposit-taking financial institution to a lender/depositor. It is calculated as a percentage of the initial value being lent/deposited (known as principal amount).

In the case of simple interest, it is simply calculated as a percentage of the principal amount, ignoring  any increase or decrease in the value of this amount over time.

For example, If you’re earning 2% interest annually on a principal amount of £1,000, you’ll get £20 every year (2% of £1,000) for as long as you commit to it.

What is compound interest?

Compound interest is often referred as “interest on interest”. This essentially means that compound interest is calculated on the principal amount as well as the interest accumulated previously.

To refer back to the previous example, in this case the £20 you get as your 2% interest on your £1,000 is then added to the underlying value that interest is calculated from in year two. This means you’ll get 2% of £1,020; £20.40.

Compound interest helps a sum grow faster compared to simple interest, and can maximise your returns, especially with larger values and over a long time-horizon.

The frequency of compounding

The rate at which compound interest grows really depends on how often compounding occurs. The higher the number of compounding periods, the faster compound interest will grow. The rate of compounding typically occurs more frequently than once a year, with popular compounding intervals being quarterly, monthly and daily.

Imagine you now have £10,000 in an ISA that pays 2% interest on your savings once a year. After 12 months, you’ll have £10,200.

If you had put it in a savings account that paid 1% semi-annually, you’d have £10,201 after 12 months.

The first interest payment would be 1% on £10,000, taking the amount in your savings account to £10,100. The second interest payment would be 1% of £10,100, so £101 – taking the total return in the year to £201.

Impact of compound interest on pension

To highlight the impact this could have on your pension, imagine you’re offered two options you may choose from: £500,000 today or 1p today doubled everyday for 30 days. Which would you choose?

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Whilst you might jump at the chance of having £500,000 today, you could get over £5 million if you went for the second option – 1p that is doubled every day for 30 days.

Of course, this isn’t at all reflective of the returns you could see investing in the financial markets, but it does help to understand how powerful compounding can be depending on the amount of money you’ve invested and the frequency at which compounding periods occur.

compound interest

You can see from the table that progress is slow at the start. It takes 15 days to get from 1p to over £160, but just 15 days after that to get to £5.4 million. Essentially, the more money you can keep in the markets instead of paying unnecessarily expensive fees, the better.

Taking advantage of compound interest could mean retiring earlier or with a better retirement income.

How can I start taking advantage of compound interest?

Here are five tips to make the most of compound interest on your investment portfolio.

1. Save up three months of outgoings and pay off expensive debt

Before you start investing, make sure you’ve paid off expensive debt and have three months of outgoings saved up in case of an emergency. This means that when you start investing, this money is ring fenced for your future so you can avoid dipping into it when you unexpectedly need money. The more money you keep invested over the long-term, the more you can benefit from compound interest.

2. Long time horizon

Perhaps the worst kept secret in personal finance, but the sooner you start saving and investing for your future, the better. A long-term time horizon allows you to take on more risk with your money, which increases your scope for higher returns, and allows you to ride out short-term fluctuations in the value of your investments. This can make a real impact over the long-run and could make all the difference to your pension income.  

3. Avoid expensive management fees and hidden charges

The more money you keep invested, the better compound interest works. When you’re paying expensive management fees for a service that isn’t performing as well as you’d like, you could be stifling your returns. The more you spend on fees, the less money you have working hard for you on the financial markets.

4. Set up a direct debit

Don’t wait until you have a lump-sum to start investing, the sooner you invest your money the quicker it will work for you. Setting up a direct debit is a stress-free way to manage your investments, and means you can ignore market noise when it comes to investing your money. You could also benefit from pound cost averaging, which can maximise your return by smoothing out the total amount you pay for an asset over time.

5. Reinvest everything

When it comes to compound interest, the amount of money you have invested and your time horizon are key. By reinvesting any dividends or interest, you can get your money working harder and quicker, allowing you to reap the benefits of compounding.

Photo by mauro paillex on Unsplash

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