Investing: 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. Simply put, you earn interest on your original savings deposit which then increases the amount in your account each year. Each year you’re 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.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 £1,060.90, which is £31.82. Each year, the amount of interest grows because it’s always calculated on your new total. The interest compounds over the years and can be a very powerful tool to grow your money. This could work in two ways. One making a single deposit left untouched – meaning no withdrawals or additional cash top ups – to grow itself over time through compound interest. Or two, 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, will be worth almost £2,500, 30 years later. With regular payments, this can grow exponentially. If David paid £1,000 in 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 will be worth more than £50,000 – more than one 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. 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 thinking, “I’m not sure if I have money to invest” consider if you can spare even a small sum each month. Just like David in our example, your money will grow over time. By starting now, your money will grow year on year, giving your future self greater peace of mind.

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