There are plenty of good reasons people choose to save and invest, from building up a rainy-day fund to saving for a retirement pot tax efficiently. One of the key benefits of starting early, and investing for the long term, is that it allows you to harness the power of compounding.
What is compound interest in simple terms?
Compound interest is the cumulative interest your savings and investments can build up over time.
It’s powerful because the return is applied not just to the initial amount you save, but any returns you also reinvest. With time (assuming the rate of return is positive), this increases the amount your original investment returns.
In other words, the effect of compound interest can help to multiply the investment return you receive over time. When you consider a pension account, in which you can lock funds away until age 55 (increasing to 57 in 2028), it’s no surprise that Albert Einstein is rumoured to have described compound interest as the ‘eighth wonder of the world’.
Can you give an example of compound interest?
Take someone who invests £5,000 in a fund which grows at an annual rate of 5% after charges. All income is reinvested.
If we assume the return is compounded monthly, the value of the investment after 10 years would be £8,235.05. Fast forward to 20 years, and you could have a pot of £13,563.20 – all from that original £5,000 initial investment.
Compare this with ‘simple interest’, which is applied to the original investment amount only.
A simple annual return of 5% on the original £5,000 only would give you £7,500 after 10 years, or £10,000 after 20 years.
Who pays compound interest?
If you’re saving with a bank, they’ll pay you your interest – usually either monthly or annually. If you leave that interest in the bank account, your balance will go up, meaning more and more interest earned each time.
When it comes to investing, the impact of compound growth will be reflected in the value of your portfolio. Providers like AJ Bell let you automatically re-invest the income (e.g. dividends) you receive on your investments.
With pensions, there’s also the tax relief payments that the government adds to the cash you pay in personally.
Learn more about pension tax relief
Regular saving and tax relief incentives really illustrate the power of compounding. For example, if you paid in as little as £80 every month to your SIPP, the government will add £20 in tax relief each time too. Over the course of 25 years, that £80 monthly pension contribution could add up to a SIPP worth over £58,000, assuming an annual investment return of 5% after charges.
How do you calculate compound interest?
You can calculate compound interest, and calculate investment growth over time, by using the compound interest formula.
The compound interest formula is: A = P (1 + r/n)^nt
Key:
- A = the amount of the future investment or savings, including interest
- P = the principal investment amount (so the amount you originally deposited or saved)
- r = the annual interest rate (written as a decimal)
- n = the number of times that interest is compounded per unit of ‘t’
- t = the time the money is invested
- ^ = to the power of
If you don’t fancy using the formula and plugging in the numbers yourself, there are plenty of compound interest tools available online. You could also use a financial calculator or other software, if have access to them.