Summary of a post.
The formidable power of compound interest
It was the great Albert Einstein who is credited with the legendary quote: “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” His adulation was echoed by English economist John Maynard Keynes, who marvelled at the sheer power of compound interest in his 1930 essay titled ‘Economic Possibilities for our Grandchildren’, and pondered the impossibility of it compounding forever.
Certainly, in the numerical sense, compound interest is infinite in both time and future value, which is why it is such an invaluable principle in the world of investment today. Compounding is the repeated addition of interest to the principal balance of a deposit. By reinvesting the interest, interest for subsequent periods is earned on the principal amount plus the previously accumulated interest, meaning the growth is exponential. This is in contrast to simple interest, which does not factor in interest earned over the previous period.
Examples of compound interest calculations
Imagine you were to invest £1,000 in a savings account which pays interest annually, with a return of 5 per cent. It’s easy enough to calculate how much you will have at the end of the first year – £1,050 (£1,000 + (£1,000 x 5%)).
However, at the end of your second year, you will have earned a total of £1,102.50 (£1,050 + (£1,050 x 5%). By compounding the interest i.e. adding it to the principal balance going forward, the annual interest received has increased from £50 to £52.50. By the third year, this increment rises to £55.13, taking the total value of the investment to £1,157.63 (£1,102.50 + (£1,102.50 x 5%).
Of course, the longer this goes on for, the greater the effect of the compound interest is, and after a certain number of years, the interest earned can exceed the amount of the principal. Here is the complete formula for calculating compound interest:
FV = P (1+r/n)nt
[FV – Future Value; P – Principal; r – Rate; n – number of times compounded per year; t – number of years]
So, for the example above, if we plug in our respective numbers, we can determine that the principal of £1,000 would have doubled sometime during the 15th year of the investment. There’s a handy ‘rule of thumb’ for working this out too, known as the Rule of 72. All you do is take the rate of interest you expect to earn, and divide it into 72. In our case, that would be 72/5, which is equal to 14.4. That is, during the 15th year!
Time and money
What the above formulas and rules also demonstrate is that the earlier one starts investing, and the more frequently interest is received and compounded, the more they can take advantage of the most powerful factor of all – time. Take the example of two siblings – one who begins the above investment of £1,000 at the age of 20, and the other at 40. By the age of 60, the former will have accumulated £7,040, which is more than seven times the original investment – even without adding a penny to it along the way.
By comparison, the latter sibling, who made their investment 20 years later, will have accumulated just £2,653 by the time they reach the age of 60 (or 2.6 times the original investment). And here’s the kicker… the difference in value between their two investments will continue to diverge over time!
Using compound interest to your advantage
It would be remiss not to observe that compound interest also works both ways, and, in theory, applies to those who take out loans too. Indeed, if you were to borrow an amount of £1,000 at a rate of 5 per cent as per the above example, the amount owed would compound if you weren’t to make any loan repayments.
Generally, this isn’t much of a factor in practice, given that loans are usually repaid in monthly instalments i.e. the same frequency as the interest is applied. One exception, however, is student loans, whereby repayments are linked to earnings. This means that lower earners could end up paying an insufficient amount to keep pace with the compounding of the interest on their loan, and the amount owed simply keeps increasing – albeit that any outstanding debt is written off after 30 years.
Nevertheless, it shows the power of compound interest at both ends of the spectrum. Yet in the context of investment, it firmly demonstrates just how vital it is to start saving and investing as early as possible, and capitalise on the most important component of all in the equation – time. So even in these times of low interest rates, don’t be deterred… the time to start squirreling away money and building a portfolio is now!
Related articles:
- Cash ISA returns: The shame of high-street banks
- The ultimate guide to your first P2P investment
- Quick guide to how our interest rates work
Get email updates for future blogs:
Our website offers information about saving, investing, tax and other financial matters, but not personal advice. If you're not sure whether peer-to-peer lending is right for you, please seek independent financial advice, and if you decide to invest with Lending Works, please read our Key Lender Information PDF first.
As with all investments, your capital is at risk.
- Summary of a post.
- Summary of a post.
- Summary of a post.
In line with our risk management framework, today we published our Q4 2019 performance update.
As a platform, we take great pride in all that we've achieved since opening our doors for business nearly six years ago. We’ve
Featured
Wednesday’s Budget speech, coupled with the cut to Bank of England rates, represented a decisive response to the coronavirus. Here we analyse the impact it will have on mitigating disruption from Covid-19, along with the long-term implications of this significant fiscal stimulus.
Rumblings from the Treasury ahead of next week's Budget suggest tax grabs will be needed to fund increased spending, and it appears UK enterprise could be in the firing line. Here we articulate why targeting entrepreneurs and small business is ill advised.
In a difficult climate, customer acquisition and lead generation present stern challenges for UK retailers, and a great deal of marketing spend invariably gets directed towards getting feet through the door.
There is a variety of literature and research illustrating the importance of building brand loyalty, albeit with some degree of variance.
Over the last decade, there can be little dispute that the reputation of mainstream banks – and particularly the so-called ‘Big Four’ (HSBC, Barclays, Lloyds and RBS) – is at its lowest ebb.
The idea of peer-to-peer (P2P) lending is a simple one; you lend money to those who wish to borrow, with a view to receiving a great return for doing so.
Most popular
The 2019-20 ISA season has been a damp squib, with banks disinterested in attracting savers’ cash, rates cut, and the stock market in freefall. However, the emergence of the IFISA means alternatives beckon for those seeking a stable middle ground in terms of risk and reward.
In a decade of slow recovery, the rapid rise in asset prices has been the standout. But how sustainable has price growth been, and could we be in the midst of a bubble?
- Summary of a post.
Most people consider income tax to be a given, but in the UK it is barely two centuries old. In this article, we look at how this tax has developed over the years, and also why it is set to remain at the core of our tax system for many decades to come.
Open banking celebrated its second birthday last month, but has the ‘revolution for financial services’ that was promised actually come to pass? In this article, we look at the progress the initiative has made so far, and what the future holds in the face of high levels of scepticism.
On the face of it, a 'broken' energy market needed fixing, and the price caps introduced in early 2019 were heralded as the solution. But, one year later, have they actually helped consumers save?
Recent
The Lending Works Shield does not give you a right to a payment so you may not receive a pay-out even if you suffer loss. The Lending Works Trustee has absolute discretion as to the amount that may be paid, including making no payment at all. Therefore, investors should not rely on possible pay-outs from the Lending Works Shield when considering whether or how much to invest. For more information click here.