Compound Interest

Compound Interest “The Eighth Wonder of the World”

None other than Albert Einstein described this amazing fact about finance, compound interest, as “the Eighth Wonder of the World”.

So, what is compound interest and why is it so important?

Compound interest is, quite literally, a form of free money… and it is free money that grows over and over again. The example detailed below explains how……..

Imagine that you invested €1,000 today and that whatever you invested it in went up by 10% this year. In this case you would have €1,100 one year later, made up from your original sum, plus €100 of interest or return on investment.

Now comes the Compound Interest: Assume you reinvested that €1,100 for another year and achieved 10% again. The following year you would have €1,210. This time you have made €110 of interest simply because the 10% interest is paid on the new balance not the original investment. Essentially, €10 of that interest is free money.

It is the interest you have been paid on your interest or, put another way, the return on your return.

At first glance this may not seem particularly exciting but over time the effect is incredibly powerful. Let’s look more closely at some examples to see just how:

The power of compounding

Let us say you decided to start investing some of your surplus income. For the sake of the argument, you wanted to invest €1,000 each year.

These might seem like numbers to small to make a difference but are they?

The two tables below detail the difference between non compound interest and compound interest.

I have illustrated at 5%, 7% and 9% growth annually, realistic expected rates of return.

These return figures are on top of your original investment !

NON COMPOUND

 

Year No.

Annual Invested

Total Invested

Return 5%

Return 7%

Return 9%

Year 1

1,000

1,000

50

70

90

Year 2

1,000

2,000

100

140

180

Year 3

1,000

3,000

150

210

270

Year 4

1,000

4,000

200

280

360

Year 5

1,000

5,000

250

350

450

Year 6

1,000

6,000

300

420

540

Year 7

1,000

7,000

350

490

630

Year 8

1,000

8,000

400

560

720

Year 9

1,000

9,000

450

630

810

Year 10

1,000

10,000

500

700

900

Year 15

1,000

15,000

750

1,050

1,350

Year 20

1,000

20,000

1,000

1,400

1,800

Interest Earned

4,500

6,300

8,100

 

COMPOUND

 

Year No.

Annual Invested

Total Invested

Return 5%

Return 7%

Return 9%

Year 1

1,000

1,000

50

70

90

Year 2

1,000

2,000

102.5

144.9

188.10

Year 3

1,000

3,000

157.63

225.04

295.03

Year 4

1,000

4,000

215.28

310.80

411.58

Year 5

1,000

5,000

276.28

402.55

538.62

Year 6

1,000

6,000

340.10

500.73

677.10

Year 7

1,000

7,000

407.10

605.78

828.04

Year 8

1,000

8,000

477.46

718.19

992.56

Year 9

1,000

9,000

551.33

838.46

1,171.89

Year 10

1,000

10,000

628.89

967.15

1,367.36

Year 15

1,000

15,000

1,078.93

1,759.03

2,642.48

Year 20

1,000

20,000

1,653.30

2,869.68

4,604.41

Interest Earned

5939.03

9412.31

13807.17

 

We can immediately see a meaningful difference between what the saver has managed to achieve after a year versus the investor.  Of far more interest is what happens over a number of years.

It is clear to see the big difference between keeping your money in a savings account and investing your money, potentially life changing, even if the amounts you start with are what you describe as “small”. Imagine, the impact can be huge depending on the amount you choose to save.

Just imagine the difference if you were saving €5000 per annum or if you transferred the cash savings you hold now and not later in life.

When Compound Interest works against you…….

It is just as important to understand that if you borrow money, the power of compounding hits you in reverse:Over time you end up paying more and more to whoever you are borrowing from.

Luke Johnson, the man behind the Pizza Express Chain and ex Chairman of Channel 4 refers to this as “…the gruesome mathematics of leverage in reverse.” This is why you must eliminate debt and get invested as soon as you can. We all know that the majority of debt is expensive. It is challenging to make a 15-20% return on your investments but almost certain you will pay at least this on your debt.

In summary

So we can see from the power of compound interest that if you can achieve a half decent return on your money, even a relatively small amount can become a very large amount in time…

This is probably the most important thing you will ever learn about money.

For Spain “The Spectrum IFA Group” is a registered trademark, exclusive rights to use in Spain granted to: Baskerville Advisers S.L. | CIF B-63/137.020 | Correduría de Seguros; No de registro RDGS J2306; | Paseo de Gracia 63, principal, 2a, 08008, Barcelona | Seguro responsabilidad civil AIG Europe No0131900503.1330 | Registro Mercantil de Barcelona, Tomo 35489, Folio 170, Seccion 8, Hoja B-269534

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