Compound interest

If managed wisely and left to grow, your savings and investments may increase faster and faster over time. With the help of compound interest, money can grow quickly.

Some people take advantage of compound growth by saving during service, others build it after leaving, and many spouses or reservists may see this effect through workplace or personal pensions over time.

Simply put, you earn interest on your original savings deposit, which then increases the amount in your account. Each month, you are paid interest on the new total in your account. It’s interest growing on interest.

However, it is likely that your interest rate will fluctuate over time. Depending on your savings account the interest rate may be fixed – meaning it stays the same – over a period of time usually between one and three years.

Alternatively, the interest rate could be variable and calculated daily based on the current balance and typically paid monthly. The interest rate can change at any time based on market conditions, which means your earnings can go up or down.

Allowing interest to compound over several years can be a very powerful tool to grow your money. This could work in 2 ways.

The first way is by making a single deposit, left untouched, to grow itself over time through compound interest. This means you would have made no withdrawals or additional cash top ups. Here’s an example, assuming the interest stays fixed.

Let’s say you start with £1,000 and earn 3% interest in the first year. That gives you £30, so your new total is now £1,030. In the second year, the 3% interest is worked out on the new total of £1,030, not just the original £1,000. That comes to £30.90, bringing your total to £1,060.90. By the third year, you’re earning 3% on £1,060, which is £31.82.

Each year, the amount of interest grows because it’s always calculated on your new total.

The second way your money can grow from compounding is by making regular payments to your initial deposit over a significant period of time.

Let’s say David, aged 20, invested £1,000 today and didn’t touch it until he reached 50 years old. The investment, left untouched, compounded at 3% each year, would be worth almost £2,500, 30 years later.

With regular payments, this can grow a fair bit. If David paid in £1,000 every year – that’s less than £100 a month – for 30 years, and the returns compounded at 3% a year, at age 50 his investment would be worth more than £50,000 – more than 1-and-a-half times the total £30,000 paid in.

The length of time that you can leave your investments to compound is very important. So the earlier you start investing, the better. And making regular contributions can boost the effect of compounding.

When investing for retirement, small investments made in your 20s and 30s can work out better than larger investments made in your 40s and 50s just because of the power of compounding.

Your willingness to start investing, whether it is early or late in life, will largely be influenced by your personal circumstances and risk tolerance. So if you are watching this and are thinking “I’m not sure if I have money to invest”, consider if you can spare even a small amount each month like David from our example.

Over time, compound interest can make your money grow much more than you might expect. Starting early, and adding even small amounts regularly, can make a big difference to your future savings.

The longer you leave your money invested, the more powerful this effect becomes, giving your future self greater peace of mind.