Compound interest is the magic behind why investing your money is so worthwhile. This is how you make your money work for you, even while you sleep – also known as a passive income.

So what IS compound interest?

This is when you put an initial (or Principal) amount into an interest paying account, and once the interest is in the account you also get interest on the interest. Warren Buffet claims this as a large reason for his wealth.

Example

You pay £1,000 into an account paying 10% interest annually, at the end of year 1 you have £1,100. Now you have the Principal plus the interest in your account so in year 2 the 10% interest is paid on £1,100 which will give you £1,210 instead of £1,200. While this is a small difference over the short-term, it makes a huge difference in the long-term.

Sticking with the current example of £1,000 initial investment and 10% interest rate, let’s see what would happen after 10 years.

Year      Compound Interest      Simple Interest

1                         1,000                            1,000

2                        1,100                              1,100

3                        1,210                              1,200

4                        1,331                              1,300

5                        1,464                             1,400

6                        1,611                               1,500

7                        1,772                             1,600

8                        1,949                            1,700

9                        2,144                            1,800

10                      2,358                            1,900

After 10 years you would have £2,357.95 due to compound interest, which gives you £457 more than if interest was only paid on the Principal amount. Now, imagine you had invested £10,000 over 10 years and this would give you an extra £4,570.

The benefits

Extra money for no extra work

This is particularly true when you save or invest over a long period. The longer you leave your money in, the more interest or growth you get on the amount reinvested – it creates a snowball effect. Also the more frequently the interest is paid, the greater the benefit.

Protection against inflation

Inflation is the extra amount of money you need to buy the same amount of goods the subsequent year (roughly 3%). This means in year 1 you could buy X amount with £100 but in year 2 the same X amount will cost you £103. Again over time this makes a significant difference. In 1990 (thirty years ago) £5,000 is equivalent to £11,622.11 in 2020. Money left in an account is therefore losing it’s value. Making use of compound interest by putting your money in an interest paying account or investing is a way to mitigate the effect of this.

Reduces the risk of not investing your money

Investing your money (for example in stocks) is a risk and you could lose your money. However, there is also a risk is not investing your money, which is losing value in an account that pays less than inflation. Can you afford not to have the potential increase in money?

Investing is not about getting rich quick; and there are ways to reduce the risk of investing. This includes investing your money:

– For the long-term (usually 5 years minimum due to volatility)

– In diverse funds (including different industries and geographies)

– On a regular basis (usually monthly)

– Considering your risk tolerance

Investing may not be the right option for you currently; if so it is still worth saving your money in the highest paying interest account available. Currently interest rates are very low so it might not seem worth looking for the best rate, but over time it will make a difference.

What is the downside of compound interest? It works against you when you take out a lending product, such as a loan or credit card.

How do you work out compound interest?

The simplest way is to divide the Principal (P) by 100 (to get 1%) and then multiple it by 100 +- interest rate (r). P/100 x (100 +- r)

Example

For example £1,000 at 5% interest would be 1000 / 100 x (100+5) = 1050

This can be shortened to 1000 * 1.05 for 1 year of growth. You could multiply the answer by 1.05 for year 2, and so on, for the number of time periods you are interested in.

A more advanced method is to use the formula:

A = P (1 + r/n) ^(n x t)

A = the initial amount and the interest

P = principal amount (the initial investment)

r = interest rate (as a decimal)

n = number of times interest applied per time period

t = number of time periods elapsed

^ = to the power of

Example

For example if you invest £1,000 for 4 years at an interest rate of 3% paid monthly

P = 1000

r = 3/100 = 0.0.3 (decimal)

n = 12

t = 4

A = 1000 x (1 + 0.03/12) ^ (12 x 3)

A = 4,132.25