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Hello again, friends! Today, we’re diving into the world of investing and taking a look at compound interest – the amazing secret behind growing your money over time. Whether you’re just starting your financial journey or looking to level up your money game, understanding compound interest is like discovering a superpower for your wallet.
What is Compound Interest?
Have you heard the term compound interest, but not really understood what it is? Think of it as interest on steroids – it’s interest not just on your initial investment, but also on the interest that accrues over time. In simple terms, it’s earning interest on top of interest, which can lead to exponential growth of your money, making your financial goals a reality faster.
Let’s review some examples
Imagine you invest £1,000 in a savings account or an investment that offers compound interest at a 5% annual rate. At the end of the first year, you’d earn £50 in interest, bringing your total to £1,050. Now, here’s where the magic happens: in the second year, you’re not just earning interest on your initial £1,000, but on the £1,050, including the interest you earned in the first year. So, at the end of the second year, you’d earn £52.50 in interest, for a total of £1,102.50.
Now, let’s fast forward a bit. After 10 years, your initial £1,000 investment would have grown to approximately £1,628.89 – and that’s without adding anything more to the pot! This is the power of compound interest – the longer you leave your money invested, the more it has the potential to grow. Not that impressive, but that £628.89 came from nowhere and is an amount you didn’t have to find and save for.
Let’s look at another example, as compound interest isn’t just for one off long-term investments. Even if you’re starting with small amounts, the principle still applies. Let’s say you invest £100 each month into an ISA (or a Roth IRA for my American friends) account that earns compound interest at an average rate of 7% annually. Over 30 years, your total investment of £36,000 would grow to around £128,872.40 – and the best part? The bulk of that growth comes from the power of compound interest, not just your monthly contributions. Imagine how that would impact your retirement and £50 is not that great a value to find and put away each month.
How does this work in real life?
The earlier you can start your investing journey, the better as it will have the biggest impact on your future, hence my wish that I knew this in my 20s! One of my favourite ways to illustrate this is to look at two scenarios.
Nisha is 20 and has learned about the power of compound interest and wants to start investing. She decides that she can afford £100 per month to put away into a Stocks and Shares ISA/Roth IRA, investing in an index fund that has an average annual growth of 10%. She will save this amount every month until she reaches age 40, then stop paying in, but leave the money invested in her ISA/IRA until she retires at age 60.
Frances is 40 and has realised that retirement is not really that far away and wants to ensure she has a good standard of living and money she can easily access at that time without financial penalty. She has a reasonably well paid job, but has never invested previously. She has also learned about compound interest and decides she wants to put away £400 per month into the same index fund as Nisha in her Stocks and Shares ISA/IRA and also plans to retire at age 60.
I have used a Stocks and Shares ISA for our example, as this UK savings vehicle allows us to invest in the stock market and is tax efficient and there will be no income or capital gains tax to pay when money is withdrawn in the future.
In this scenario Nisha will have invested a total of £24,000 and Frances will have invested £96,000. Let’s see what happens when each woman reaches the age of 60 and how much they have in their investment accounts for their retirements.
| Nisha | Frances | |
| Total Invested | £24,000 | £96,000 |
| Total Interest | £537,841.13 | £210,678.76 |
| Total at 60 | £561,841.13 | £306,678.76 |
Nisha, after 20 years of investing £100 per month, has £76,669.69. This is then left in her Stocks and Shares ISA, without withdrawal or deposit for another 20 years and balloons to £561,841.13. All she had to put in was £100 per month aged 20-40 and she has over half a million at age 60.
Frances invests £400 per month for 20 years and her investment grows to £306,678.76. Not a figure to be sniffed at either, but is £255,162.37 behind Nisha for an extra investment of £72,000! Each woman in this example has invested in their ISA for 20 years. Nisha a smaller amount at an earlier age and Frances a larger amount from later in life.
A saying that fits this well is “time in the market is better than timing the market”. Being invested long term in a good index fund, for the majority of people, is far preferable to trying to time the ups and downs of individual stocks where ot is easy to get things wrong and lose money. Working on market averages over a long period will yield great results if you remain patient and sit tight through the turbulence.
How can I work out compound interest for myself?
I use this Compound Interest Calculator which is available online. I like this one as it is really easy to use and visually simple. This would be the one I recommend, but there are others available.
What about risks?
While compound interest is a powerful tool for growing your wealth, it’s important to remember that it works both ways. Just as it can amplify your gains, it can also magnify your losses if you’re not careful. As always, it’s crucial to do your own research, diversify your investments, and seek guidance from financial professionals.
In conclusion, compound interest is like a turbo boost for your finances – it has the potential to turn small investments into substantial wealth over time. By harnessing its power and being patient, you can set yourself up for a brighter financial future. So, start early, stay consistent, and let compound interest do its magic!
Disclaimer
I am not a financial advisor and this post does not constitute financial advice. I am solely sharing my own opinions based on my own experiences. It is recommended that you seek the advice of a financial professional before making any decision about whether investing is right for you. Investing carries risk, and you may get back less than you put in. Previous performance of a fund is not an indication of future performance.
For financial advice, I recommend visiting financialadvisers.co.uk who can match you to a professional for expert advice.
Have you started investing? What are your goals? Let me know in the comments.
Need ideas to save money so you have some extra money available to invest regularly? Check out this post.
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