To (allegedly) quote a genius; “Compound interest is the eighth wonder of the world.”
Einstein was famously right about most things, and this is no exception. If the term isn’t familiar to you, you may have heard it by another name: the snowball effect.
Simply put, compound interest is the act of earning interest on the interest of your initial deposit.
It’s the reason why interest rates on credit cards and savings accounts are so vitally important when you are considering taking out a new financial product.
Ask yourself; do you really understand what compound interest means and how it works? Most importantly: do you understand how it can work to both the betterment and detriment of your finances?
An example of compound interest at work for your benefit
Let’s say you have just been given £1,000 to spend as you please. For argument's sake, you decide to put it in a savings account that offers 10% annual interest. Over five years this is how compound interest can really help your money work for you.
Clearly 10% is a very generous interest rate, but it serves to demonstrate the power of compound interest on your finances. You can see that in just five years, with a 10% annual interest your money has increased by over 60% and you didn’t have to lift a finger. The £610 is growth you have earned purely on your money’s interest.
The effects of compound interest obviously increase over time. By leaving your money to grow there will be an even more dramatic increase as the years progress and your money builds on itself.
After 30 years of 10% interest, if you do nothing other than wait patiently, that initial £1,000 will have turned into a whopping £17,449.
This is why it’s always better to start saving as early as you can, so that your money has more time to grow.
However, it’s worth noting that compound interest is a force that can be used for evil as well as good. See the example below to understand how compound interest working on your credit card debt can be financially destructive if you're not careful.
An example of compound interest at work to your detriment
In this example you have decided to spend £1,000 on your credit card to buy a week away in Spain. The annual interest rate on your repayments remains 10% (as above). However, as most credit payments are required on a monthly basis this calculation will compound the interest on a monthly basis, not on an annual one as in the example above.
This discrepancy between the way credit cards and savings are compounded is just one way that banks use compounding to their advantage, as if interest is compounded more frequently, it will earn greater interest over time.
Let’s also say that for some reason you are not paying anything towards your credit card each month for these five years and the bank just lets that go.
This means that over five years this is how your debt will grow.
In just five years you will owe more than half again of the original amount you borrowed, all due to compounding. This is the reason why it is always advised to tackle debt as swiftly as possible, and pay off as much of the balance as you can with each payment. The faster you pay back the debt the less chance you give it to snowball out of your control.
If you want to run calculations for yourself then there are a number of fantastic compound interest calculators you can use to run your own numbers.