“Compound interest is the 8th wonder of the world.”
The above quotation is usually attributed to theoretical physicist and Nobel laureate Albert Einstein.
Whether he actually said it or not isn’t entirely clear, but the sentiment behind the quotation remains as valid now as when it was originally uttered (whoever the utterer was).
Compound interest, or “compound growth”, is the reason that your investments can snowball over time. It’s a fundamental concept in finance and a vital part of investment projections and forecasting.
But what is compounding, why is it such a crucial part of long-term investing, and how can you make the most of it now?
Keep reading to find out.
Compounding means receiving interest on interest
When you place your cash into a savings account you expect the money to accrue interest.
Savings rates have been particularly poor over recent years, meaning that savers have had a difficult time of it. But the rate of interest isn’t the end of the story – It’s the power of compounding that can really save the day.
If your bank account has an interest rate of 2.5% and you deposit £1,000 into it, you’ll expect £25 interest after 12 months.
Even if the rate of interest remains at 2.5%, though, the amount you receive in year two will be different. This is because in year two you don’t receive 2.5% on the initial £1,000, but on the new amount of £1,025.
In this example, 2.5% of £1,025 is £25.63. This is the effect of compound interest.
The extra 63p in year two might not seem like a big deal, but in year three the interest you receive will be 2.5% of £1,050.63 (£26.27) and so on. Over time, as these numbers grow and you continue to receive interest on interest, the effects of compounding become huge.
And it isn’t just your savings accounts that benefit from compounding. Investments like Stocks and Shares ISAs, and even your pension, take advantage of compounding too.
Reinvesting the dividends you receive from an investment will increase the size of your pot and so, hopefully, the size of the dividend you receive next time. Dividend reinvestment is a powerful compounding tool so be sure to speak to us if you’d like to discuss the dividends you receive.
The effects of compounding grow over time so starting early is key
Compounding growth means that the interest you receive increases each year. It stands to reason that the earlier you start saving the better.
The plans we put in place for you are always long term.
This is to ensure that your money has the time to recover from the kind of short-term volatility we’re seeing in the markets currently. The sooner you start regular contributions, the more you will contribute.
But compound growth is another key reason to start early and think long-term.
Having a long-term retirement plan in place as early as possible can increase your chances of retiring earlier in life and improve the lifestyle you can live once you finish work.
It’s never too late to start benefiting from compound growth
While the effects of compounding increase over time, that’s not to say it’s ever too late to start saving.
You will find, though, that the later you start saving toward your pension, the greater the percentage of your monthly income you’ll need to put aside.
The rule of thumb is to halve your age and then put that percentage of your monthly income into a pension.
So, if you start your pension contributions at the age of 20, you’ll only need to part with 10% of your income each month. Start saving at 50, though, and you’ll need to find 25% of your salary each month. This is an important lesson to pass on to children and grandchildren.
If you would like to revisit your pension planning to ensure you’re saving enough, get in touch now.
Get in touch
At Globe IFA, our expert financial advisors have decades of combined experience and can help you with any aspect of your long-term financial planning. Please email hello@globeifa.co.uk or call us on 020 8891 0711 to discuss any concerns you have.
Please note
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
