The power of Compound Interest

Albert Einstein once described compound interest as the “eighth wonder of the world,” saying, “he who understands it, earns it, he who doesn't, pays for it.”


Compound interest is when the interest one earns on a principal balance is reinvested and generates additional interest.


Warren Buffett calls it the most important factor in successful investing. Even better, every single investor can profit from “man’s greatest invention”, not just geniuses or billionaires.


The compound interest effect refers to the snowball of money that grows on your behalf when you reinvest your interest.


Interest on interest on interest (or dividend) payment you put to work in the market today will generate more interest for you tomorrow. That’s because your interest also earns interest. And the longer you give your interest to pile up, the mightier your snowball becomes. Let’s look at a practical example to illustrate the compound interest effect.


If you invest $10,000 at a 5% rate of return then you will earn $16,288.95 over ten years, not just $15,000.


The compound interest effect creates an extra $1,288.95 that you would not have earned if you had just spent the interest every year. The effect becomes more powerful over time.


Imagine that an investor, we’ll call him John, he wants to save up a retirement fond of £100,000 by the time he retires at age 65.


The chart shows how much John needs to put away to reach his goal depending on how soon he starts saving. We assume an annual growth rate of 5%, which is quite conservative by the standards of the last 40 years.


The key takeaway is that the longer compound interest gets to work its magic, the less John needs to pay in himself.


If John does nothing until age 60 then he needs to find a whopping £1,468.64 per month to hit his target. There is little time for compound interest to help his cause.


But if some smart relative or parent starts saving for John from the day he is born then only £17.77 needs to be found a month. A small amount for John to save himself once he starts earning.

Even if John waits until age 25 then he need only put aside a modest £67.18 per month to reach £100,000 by 65.


The difference in required savings between each of the start dates is how much of the £100,000 is taken care of by your accumulating interest payments.


Even small contributions can snowball if compound interest is given enough time to generate its own momentum.


Let your money do the work and If you start early enough then compound interest payments will eventually surpass the amount of money that you pay in.


Small steps can make a big difference in developing the financial well-being of ordinary people. This includes actions taken with respect to basic financial practices such as budgeting, banking, and borrowing.


Think Long Term: Successful investing is a decades long venture. It is not timing the market that matters but, rather, time in the market. Follow a dollar-cost averaging strategy by investing regular amounts at regular time intervals.


Small amount of money can make a difference if we analyse the impact in the long term. Whether you invest, cut down on expenses, pay life insurance or increase the repayment on your loan, the impact is massive. Therefore the impact of small steps and consistency on money management is very big.


Returning to our John example, you can see how much of his £100,000 target comes from compound interest the orange bar versus paid in savings the white bar.


John would only need to save £13,856.99 over the course of his life to hit £100,000 if those kindly relatives get him going as a newborn.


In this scenario, John’s interest payments are 6.2 times greater than his actual paid in savings! Compound interest does the vast majority of the work bringing home £86,143.01 without John having to lift a finger.


The 25 year old John is in a comfortable position as well. About two thirds of his £100,000 comes from interest payments. He only has to personally find £32,245.83.


An early start benefits you in the long run The earlier you can start saving, the more compound interest will do the heavy lifting for you.


It’s one of the most valuable yet underestimated factors in an investor’s long-term plan because its effect is relatively imperceptible at first.


Compound interest is the financial equivalent of the old Chinese saying: The man who moves a mountain begins by carrying away small stones.


The greater your return on investment, the more powerful the compound interest effect becomes, which is why its best leveraged by reinvesting the profits you make in the stock market.


Even small monthly contributions will be sufficient to save £100,000 and more over time. Monthly saving is made easy when you use ETF saving plans. They enable you to invest a regular amount into a diversified basket of stocks such as an MSCI World ETF.


In case you want to do any calculation for your own, there are plenty of Apps or websites that will automatically do the calculation for you. We leave one of them for you here.

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