Updated 03 December 2020
Compound interest has been called ‘the eighth wonder of the world’ (possibly by Albert Einstein, perhaps by someone else). The quote continues: ‘Those who understand it, earn it; those who don’t, pay it’. Compound interest allows sums of money to grow exponentially over time, like a rolling snowball – sometimes turning small investments into huge returns, and sometimes turning a small debt into an unpayable bill.
Here we’ll look at compound interest as it applies to investing, and explain why you need to factor it in when making any investment over a number of years.
Both loans and investment products typically involve a compound interest rate. Compound interest differs from simple interest, which is only generated on the principle, i.e. the amount you initially deposit or borrow. By contrast, compound interest is calculated using both the interest on the principle amount, and also the interest you’ve already accumulated up to that point. In other words, you earn (or pay) interest on the interest.
If you’re borrowing money, a compound interest rate works in the lender’s favour. For example, if you’re always at the limit of your credit card, and only pay off the minimum amount each month, the interest on the amount you owe will increase every year. However, if you’re saving or investing, compound interest will increase the amount by which your money grows every year, because every year there is a larger sum to earn that interest.
As the name implies, simple interest is calculated in a simple way. All you have to do is multiply the original (‘principle’) amount by the interest rate, to get the amount of interest paid per year. You then multiply this figure by the number of years the money is invested (or loaned).
In practice, simple interest is rarely used in the world of investments. Compound interest is more favourable to investors, and works like this. The first year of interest is calculated as above: by multiplying the principle amount by the interest rate. So £100,000 at 4% interest (100,000 x 1.04) will be £104,000 at the end of the first year.
Now this amount becomes the principle. In year 2, you multiply £104,000 by the same interest rate (104,000 x 1.04) to get £108,160. Notice how in the first year you made £4,000 interest, but in the second year you made £4,160.
Carry on doing this for each year of investment, and you’ll see how the amount of interest increases year by year as the overall investment grows. After 10 years of this, you’d be looking at a final balance of £148,024 and the final year’s interest would be £5,693.
For the curious, compound interest is worked out with the equation [x(1+y)n - 1]-x where x is the original amount, y is the interest rate and n is the number of years invested. But it’s much easier to think about it using the example above!
When and how the interest is compounded can also make a big difference. For instance, in the example above we’ve assumed that the 4% interest is simply added on at the end of each year. But many investments may compound their interest at more frequent intervals, such as quarterly or even monthly. The annual interest is still the same (e.g. 4%) but the interest is added throughout the year. This can have a substantial effect on the total interest paid.
In the example above, if interest is compounded monthly, then by the end of the first year the £100,000 sum has grown to £104,074 – i.e. it has an extra £74 added on, because the interest was earning more interest from the end of month 1 onwards. After 10 years of this, the balance would be £149,083 – i.e. over a thousand pounds more than interest compounded annually.
Because of the ‘snowballing’ way in which it acts, compound interest can generate seriously impressive returns if left to work for long enough. The higher the number of compounding periods (i.e. years invested), the more interest you will generate.
Bear in mind that this only works to full effect if you are leaving the investment untouched, i.e. investing for growth. If you are investing for income, you will be drawing out the interest regularly, so it will not compound effectively.
A useful variant of compound interest is dividend reinvestment. This is the process of reinvesting dividend payments (which some companies pay on some shares) to buy more shares. As with any form of investment, you do risk losing your dividends if you choose not to cash them in. However, carefully considered reinvestment in dividend growth stocks, or manual dividend reinvestment, can act as a ‘compounding accelerator’ to keep your money growing.
Thinking about early investments is vital if you want to enjoy maximum growth without excessive risk. Even if you’re in your 20s, it’s wise to start your pension early to make sure you can live comfortably even after you stop working. Starting to invest your money in relatively low risk, compound interest products 30-40 years before you plan to retire will allow your pension pot to grow steadily over time. In the world of compound interest, time literally is money.
Early investment also means you don’t have to choose high-risk investments to see substantial returns, so you’ll be less likely to lose the principle amount. If you don’t think about investing for retirement until later in life, you’ll have to consider higher risk options to get the same kind of returns or accept the lower returns you get from conservative investments.
Many different types of investment offer impressive rates of compound interest. Fixed-rate ISAs, both the cash savings and stocks and shares varieties, can give you access to good compound interest rates. Generally, the longer you’re willing to tie your money up for, the better your returns will be. You can also invest in:
Bonds can offer good returns on your investment, though the yield will depend on your appetite for risk. Investment grade bonds are generally considered low risk – rated between BBB and AAA on Moody’s scale. Government bonds, also known as treasuries and gilts, are considered the most secure investment options, though there are plenty of high-quality corporate bonds worth investing in too.
Anything rated BB or below is called a ‘junk bond’, and as the name implies poses a significantly higher risk. Junk bonds are issued by less secure businesses like startups, firms with poor debt to credit ratios and ‘fallen angels’ which have lost their high credit rating. These bonds will offer much higher interest rates as they’re more likely to default, which would mean you lose most or all of your investment. However, if the company manages to turn its fortunes around, it could mean a higher payday for you when you cash in the bonds. As ever, it’s about weighing up the risks and rewards.
A financial adviser can not only help you choose the right products to invest in, but also work out the right periods of time over which to invest, so that you can make the most of compound interest. Working this out can be the challenging part, as it depends on your own investment goals and your overall plans over the next 10 to 20 years. All of these areas are an IFA’s specialism, which is why advice can be so useful here.
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