What Is Compound Interest?

Woman reading book in a field

If you’re looking to invest or save money, you may have come across the term “Compound Interest”.

Compound interest is a way of enhancing your interest by re-investing your initial investment and profits back into your money. Be it a stock, shares, savings account, or anything similar. Simply put, you earn interest on previously earned interest.

“My life has been a product of compound interest.”

Warren Buffett

As the old saying goes, “money makes money”, and it’s most definitely true. The longer you leave your money to compound, the greater the returns become over time.

How Does Compound Interest Work?

To understand compound interest more, people tend to look at it like a “snowball effect”. The more you roll the snowball around in the snow, the bigger it’ll become.

This is the same circumstance for compound interest where you don’t just earn interest on the initial balance you invest into the asset. You’ll keep adding the interest you’re already making on the investment back into it or compound it with more funds.

Compound Interest Example

To explain this concept better, let us show an example of compound interest.

You put £1,000 into a savings account that has an annual interest rate of 5%. After the first year, your new balance will be £1,050, giving you an extra £50. Now, fast forward another year. Your balance of £1,050 will now be £1,102.50, giving you an extra £2.50 on top of the normal 5% on the £1,000.

As you can see from the above, by compounding your investments, you’ll make more money each year, providing it has the same stable level of interest. If you left that initial investment of £1,000, in your 5% interest savings account, in 30 years time, you’d end up with a total balance of £4,321.94.

“The first rule of compounding: Never interrupt it unnecessarily”

Charlie Munger

Investors manipulate this powerful strategy by combining both additional funds and interest made from the asset. So, going back to the principle investment of £1,000 with a 5% annual interest. If you compound both the interest and add an additional £100 into your account each month for 30 years, your total amount will accumulate to £84,048.56. You would have added £37,000 and would have earned £47,048.56 in interest.

How To Calculate Compound Interest

If, like me, you find yourself wanting to know the formula for calculating compound interest then here you go!

  • Formula: P((1+i)Y)– 1
  • Key: P – Principle investment, i – Interest rate, Y – Years compounded

Using the previous amounts, this would look like: £1,000((1+0.05)30)-1

What to check when looking at compound interest savings accounts

When wanting to perform compound interest on an investment, here are some variables you should consider.

  • Interest rate stability – To execute compound interest successfully, you need to invest in something that’ll comfortably provide the same levels of interest each year. One option to look into for a long-term, stable interest rate are savings bonds.    
  • Starting capital – How much are you willing to invest? The more significant the initial investment, the better your returns will be.
  • Frequency of compounding – Make a realistic judgment on how much money you can spare each month or year on compounding your investment. For inspiration, you should use this calculator to see the possible outcomes.
  • Time scale – The longer you compound for, the more money you can potentially earn. In most cases, the longer you “trap” your money into a savings account, the better interest rate a bank will offer you. A perfect option for a long-scale savings account is a lifetime ISA

Remember, compound interest is a marathon, not a sprint. But a greatly rewarding investment if you’re able to stay disciplined when saving your money

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