Compound interest is a financial term often heard but little understood. It’s something you’ll commonly see associated with borrowing products, including loans and credit cards, and with savings accounts and investments.
Albert Einstein perhaps said it best: ‘Compound interest is the eighth wonder of the world. He who understands it, earns it… He who doesn’t, pays it.’
The key is to recognise when compound interest may be in your favour so you can leverage that knowledge to maximise the value of your savings.
Let’s demystify this term by explaining how compound interest works, and why it can be an investor’s best friend, yet a borrower’s worst nightmare.
What is Compound Interest?
The technicality of compound interest belies a very simple principle. As with so many financial markers, providers sometimes use terminology that tangles consumers and is often buried beneath reams of fine print. In essence, compound interest works the same way regardless of the product it is applied to.
Any interest you earn or owe is added to the original balance. Whether you’re gaining it or paying it, the next batch of interest is then calculated against the new total, consisting of the initial value plus the interest earned on top, since the last time the interest was calculated.
That’s all there is to it.
Therefore, the distinct advantage of compound interest is that the longer you hold savings, the more they will grow. With no limit on compound interest accumulating, you can multiply your savings many times over if they are held for long enough.
Conversely, compound interest can be crippling for those in debt.
We’ll explore this a little further below, but it’s vital to understand that just as compound interest can increase savings, it can also multiply debts until they spiral out of control.
The Disadvantages of Compound Interest on Borrowing Products
You can find compound interest in any range of credit facilities. That can include loans, credit cards, asset finance, and other personal or commercial borrowing products.
Compounding can occur annually, monthly, quarterly, or even daily – which can substantially change the affordability of a credit account.
Student loans are a prime example of the risks of compound interest – and the accumulating balance can swiftly overtake any repayments being made, with the balance owing seeming to grow ever larger with each passing period.
For example:
- A student has university fees of £10,000 per year, charged via a student loan account with interest of 5% per annum (for illustration purposes).
- Their course lasts for three years, with fees beginning from year one, and they don’t need to make repayments until the year after the course finishes.
- In year one, they are charged £10,000 plus a 5% interest charge, so they have a debt of £10,500.
- By the end of year two, they have racked up a second £10,000 fee, plus 5% including the year one debt of £10,500, so the balance is now (£10,500 + £10,000 x 5%) £21,525 – even if the course costs are only £20,000.
- When they finish the course at the end of year three, their debt stands at £33,101.25. That’s £30,000 in course fees and over £3,000 in compound interest.
Let’s say that the same student makes minimum repayments, starting when they finish their degree, in line with the standard 3% repayment value. In year four, they might repay £993. However, compound interest continues. A further 5% is added to the £33,101.25 balance. The total now stands at £34,756.31 – less the £993 repayment; the loan is still higher than at the end of the previous year when the student hadn’t repaid anything.
Compound interest can cause debt levels to spike. Making the minimum repayment often won’t touch the surface of the accumulating interest, thus causing no end of financial hardships.
Using Compound Interest to Grow Savings
Much as compound interest can create unmanageable debts, savers can also use it to their distinct advantage. The key to using compound interest to increase your cash is that it is the longer you save, rather than the amount you save, making the most significant difference.
Here are two comparisons to illustrate that point:
- Saver A opens a savings account with a £100 deposit and pays in £100 per month, from age 30 until they retire at age 60. They earn 10% interest a year and end up with a balance of £208,029. Not a bad return, given their savings contributions, were only £36,100.
- Saver B makes the same savings into the same account, but they start ten years earlier, at age 20. Their balance is £559,561 – an extra £351,532 in retirement funds, against additional savings deposits of £12,000.
There is a ‘magic number’ at which your savings begin to grow exponentially – and in this case, we can see why making extra contributions for ten years can be dramatically advantageous. Between year 39 and year 40 alone, this account earns interest of over £46,000.
Hence the duration of a compound interest savings account or investment making a tremendous impact on the earnings available. There is a resource available at The Calculator Site where you can run through illustrations and see the impact.
Other factors will be at play in real life, such as changing interest rates, inflation, and variations in contributions or withdrawals. Still, the principle stands: the longer you save, the greater your savings growth.
Harnessing the Power of Compound Interest
The benefit of compound interest is that it can make your money grow faster and continue gaining momentum the longer you save.
The illustrations we have explored look at annual interest – but consider if that interest were calculated monthly. You can quickly see how values can skyrocket in a relatively short time.
Compounding is the proverbial snowball – it will roll faster, quicker, with greater force the longer it is allowed to move without interruption. From an investment viewpoint, the gains are limitless.
The key to intelligent investment isn’t just to evaluate interest rates, compounding periods, contribution rates, and that sweet spot at which interest earned begins to exceed the capital invested. It is to balance out other factors, such as:
- Tax levies and thresholds at which they may make a dent in profitability.
- Risks, such as currency exchange rates and inflation.
- Appetite for risk exposure, and where the potential for losses counterbalances lucrative interest rates.
Compound interest, as we’ve said, is a straightforward concept. Yet, we cannot underestimate the power of this financial calculation. As a force for significant gains or a calculation leading to severe losses.