What is compound interest 

Compound interest is the long term saver and investors best friend. It simply means earning interest on interest, and has been described as the eighth wonder of the world.

It is what happens when you reinvest interest, instead of having it paid out, and then spending it.

The longer the time period involved, the more accumulated interest can grow, and earn more interest on interest and so on.

What is compound interest example

As an example, If I had £1,000 at the start of year one, and earned 10% per year on that sum, at the end of year one I would have £1,000 + £100 of interest.

If that interest was then reinvested, I would now have £1,100 at the start of year two. The same 10% rate of return would then generate £110 of interest in the second year. The extra £10 being interest on the interest.

At the start of year three, I now have £1,210. A year later, using the same 10% rate of return, I have now earned £121. Some of this is interest on interest, and another slice is now interest on interest on interest!

The compounding effect is particularly powerful over decades of investing, and a significant part of your overall final return will have been effectively created from thin air, otherwise known as interest on interest. This is why it is essential to know what is compound interest.

If we take another look at the previously seen investment growth table as set out below. 40 years worth of £250 per month contributions, is the equivalent of £120,000 paid in. However, the value of the 10% growth column after 40 years, shows a figure of £1,581,019. This means circa £1.46m has been created by investment growth and the wonders of compound interest.

If the investor in our example table was able to generate an average return of 15% per year, then after 40 years, their pot would be worth a staggering £7.75m! And even more amazingly, most of that has again been created by compound interest.

 

Be warned about compound interest in reverse

Be warned though, compound interest can work in the opposite way if you are in debt. Instead of you earning interest on interest, your bank will be earning it, and you will be paying it if you don’t keep up with your debt repayments.

Albert Einstein was reported as saying “He who understands compound interest earns it, he who doesn’t, pays it.”

As someone mastering the art of financial literacy, you will fully understand what is compound interest, and make sure it works for you and not against you.

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