Albert Einstein is best known for his expertise in physics. Not financial advice. However, the Nobel Prize winner is often quoted as calling compound interest “the 8th wonder of the world.” Why? It’s because of the way that it helps your money to work for you and grow by itself.
What is Compound Interest?
Interest rates are often in the news. However, there are actually two different types of interest, simple interest and compound interest. Simple interest is the return you get paid for putting your money away for a period of time. The more money you put away, the more interest you earn. Compound interest builds on that idea. As well as earning interest on the amount you save, you also receive interest on the interest you earnt in the previous period. Which is known as compounding. ‘Interest on interest’ means that your money continues to grow regardless of whether you add more to your savings or not. As a result, compound interest is a more powerful way to increase the value of your savings compared to simple interest. That’s because you earn more for investing the same amount.
Why it Pays to Start Saving Now
With simple interest, the amount you earn from saving depends on how much you save and what rate of interest you earn. However, with compound interest, there’s another critical factor … time. How long you save is as important as how much money you put into your savings. To see why time is so important, look at some examples of compounding with investments: Person A invests £5k per year from the age of 18 until they are 28. Over this time, they’ll have invested £50k. Person B invests £5k per year from the age of 28 until they retire at 58. They’ll have invested £150k. Person C invests £5k per year from the age 18 to when they retire at 58. They’ll have invested £200k in total. Then assume that there’s the same 7% return on all the investments that A, B and C make. Whilst B has invested 3 times more than A, B’s investment will be worth about £510k. Whereas A ends up with a pot worth over £600k. However, Person C has the best overall result. By starting their investment at the same time as A and B and continuing to invest until they retire, C finishes with their investment worth the most, at over £1.07m.
How Compound Interest Helps Your Pension to Grow
As it works with investments as well as savings, it’s a way to help your pension grow. With investments in shares, the shareholders receive dividends as their share of the profits. Which is like the interest you get paid on a savings account. So when the dividends are reinvested to buy more shares, you have the chance to benefit from compounding interest.
What Are The Downsides?
Compound interest relies on a positive rate of return from your investments. However, if the value of your investments falls, such as the price of stocks and shares, this can reduce the benefits of compounding. As a result, it’s important to review your investments over time as there is a risk that you may get back less than you invested.
How Compound Interest Can Work for You
Compound interest helps your savings and investments to increase their value. When you hold investments like your pension over a long period of time, you’re able to benefit from compounding. That’s because the amount of time you’re invested for is as important as how much you invest. If you want help or advice with your pensions and investments, contact us for a call with one of our independent advisors. Give us a call on 0345 224 3175 to book an appointment.
What is the minimum amount I need to start with compound interest?
There’s no fixed minimum amount to start with compound interest. Even small contributions can make a difference over time. The key is to start as early as possible.
Can compound interest work with any type of investment?
Yes, compound interest can work with various types of investments, including savings accounts, stocks, bonds, and mutual funds.
How often should I check my investment portfolio?
While it’s essential to stay informed, checking your portfolio too frequently can lead to impulsive decisions. A quarterly review is generally sufficient for most long-term investors.
Is compound interest affected by market fluctuations?
Yes, market fluctuations can impact the rate of return on your investments. However, compound interest still works its magic over time, even with market ups and downs.
Can I withdraw money from my compound interest account?
Yes, you can withdraw money from your compound interest account, but doing so may slow down your wealth accumulation. It’s best to leave your investments untouched for the maximum benefit.
Are there any tax implications with compound interest?
Yes, depending on the type of investment and your country’s tax laws, there may be tax implications. Consult a tax advisor for personalised guidance.