Compound interest: how it works in saving and investing

Compound interest has been called ‘the eighth wonder of the world’ by Albert Einstein.

The quote continues: ‘Those who understand it, earn it; those who don’t, pay it’.

Compound interest allows sums of money to grow exponentially over time, like a rolling snowball.

Sometimes, it can turn small investments into huge returns, or sometimes, it can turn a small debt into an unpayable bill.

Here we’ll look at compound interest as it applies to investing, and explain why you need to factor it in when making any investment over many years.

What is compound interest?

Both loans and investment products typically involve a compound interest rate.

Compound interest differs from simple interest, which is only generated on the principle, i.e. the amount you initially deposit or borrow.

By contrast, compound interest is calculated using both interest on the principal amount and the interest you’ve already accumulated up to that point.

In other words, you earn (or pay) interest on the interest.

If you’re borrowing money, a compound interest rate works in the lender’s favour.

For example, if you’re at the limit of your credit card, and pay off the minimum amount each month, the interest on the amount you owe will increase every year.

However, if you’re saving or investing, compound interest will increase the amount by which your money grows annually as every year there is a larger sum to earn that interest.

How to calculate compound interest vs simple interest

As the name implies, simple interest is calculated in a simple way.

All you have to do is multiply the original (‘principal’) amount by the interest rate, to get the amount of interest paid per year. You then multiply this figure by the number of years the money is invested (or loaned).

In practice, simple interest is rarely used in the world of investments.

Compound interest is more favourable to investors and works like this.

The first year of interest is calculated as above: by multiplying the principal amount by the interest rate.

So £100,000 at 4% interest (100,000 x 1.04) will be around £104,000 at the end of the first year.

Now, this amount becomes the principle.

In the second year, you multiply £104,000 by the same interest rate (104,000 x 1.04) to get over £108,000.

Carry on doing this for each year of investment, and you’ll see how the amount of interest increases year by year as the overall investment grows.

After 10 years of this, you’d be looking at a final balance of around £149,000.

For the curious, compound interest is worked out with the equation [x(1+y)n - 1]-x where x is the original amount, y is the interest rate, and n is the number of years invested.

But it’s much easier to think about it using the example above.

Interest compounded yearly vs monthly

When and how the interest is compounded can also make a big difference.

For instance, in the example above, we’ve assumed that the 4% interest is simply added on at the end of each year.

However, many investments may compound their interest at more frequent intervals, such as quarterly or even monthly.

The annual interest is still the same (e.g. 4%), but the interest is added throughout the year. This can have a substantial effect on the total interest paid.

How does compound interest help grow my investments?

Because of the ‘snowballing’ way in which it acts, compound interest can generate seriously impressive returns if left to work for long enough.

The higher the number of compounding periods (i.e. years invested), the more interest you will generate.

Bear in mind that this only works to full effect if you are leaving the investment untouched, i.e. investing for growth.

If you are investing for income, you will be drawing out the interest regularly, so it will not compound effectively.

A useful variant of compound interest is dividend reinvestment. This is the process of reinvesting dividend payments (which some companies pay on some shares) to buy more shares.

As with any form of investment, you do risk losing your dividends if you choose not to cash them in.

However, carefully considered reinvestment in dividend growth stocks, or manual dividend reinvestment, can act as a ‘compounding accelerator’ to keep your money growing.

The importance of starting to invest early

Thinking about early investments is vital if you want to enjoy maximum growth without excessive risk.

Even if you’re in your 20s, it’s wise to start your pension early to make sure you can live comfortably even after you stop working.

Starting to invest your money in relatively low-risk assets, compound interest products 30-40 years before you plan to retire will allow your pension pot to grow steadily over time.

In the world of compound interest, time literally is money.

Early investment also means you don’t have to choose high-risk investments to see substantial returns, so you’ll be less likely to lose the principal amount.

If you don’t think about investing for retirement until later in life, you’ll have to consider higher-risk options to get the same kind of returns or accept lower returns you get from conservative investments.

What investments give good compound interest?

Many different types of investment offer impressive rates of compound interest.

Fixed-rate ISAs, both the cash savings and stocks and shares varieties, can give you access to good compound interest rates.

Generally, the longer you’re willing to tie your money up, the better your returns will be. You can also invest in:

• Dividend-paying stocks (for dividend reinvestment)
• Real estate investment trusts (REITs)
• Exchange-traded funds (ETFs)

Bonds can offer good returns on your investment, though the yield will depend on your appetite for risk.

Investment grade bonds are generally considered low risk – rated between BBB and AAA on Moody’s scale.

Government bonds, also known as treasuries and gilts, are considered secure investment options, though there are plenty of high-quality corporate bonds worth investing in, too.

Anything rated BB or below is called a ‘junk bond’ and, as the name implies, poses a significantly higher risk.

Junk bonds are issued by less secure businesses like startups, firms with poor debt-to-credit ratios and ‘fallen angels’, which have lost their high credit rating.

These bonds will offer much higher interest rates as they’re more likely to default, which would mean you lose most or all of your investment.

However, if the company manages to turn its fortunes around, it could mean a higher payday for you when you cash in the bonds.

As ever, it’s about weighing up the risks and rewards.

How can a financial adviser help me grow my investments?

A financial adviser can not only help you choose the right products to invest in but also work out the right periods of time over which to invest so that you can make the most of compound interest.

Working this out can be the challenging part, as it depends on your own investment goals and your overall plans over the next 10 to 20 years.

All of these areas are a financial adviser's specialism, which is why advice can be so useful here.

If you found this article interesting, you might also find our article on pension or property investments informative, too.