Compounding - Earn Interest On Interest
Compound interest is the key to growing your money over time, but what does it actually mean to compound?
Well, compound interest is defined as: “the addition of interest to the principal sum of a loan or deposit”.
In other words, it means you’re earning “interest on interest”.
So how does it work?
Say you have saved £1,000 and have it in an account with an interest rate of 5%. After one year your £1,000 would have earned £50 in interest, growing your savings to £1,050.
Wait another year and you would have earned an additional £52.50 in interest, resulting in £1,102.50 in savings. The extra £2.50 came from earning interest on top of your new total after 1 year of saving. This is the power of compounding!
Now, imagine what would happen if you kept the money in the same account for the next 10 years:
The impact of compounding grows over time, but it becomes even more powerful if you were to to keep adding more savings to your account.
Let’s look at what would happen if you started depositing £10 every month for the 10 year period:
So even though you only deposited an extra £1,200 over 10 years, you’ve earned £350 extra in interest - thanks to compounding!
Even better, the compounding effect continues to get greater the longer you save.
The final component to maximising the returns on your compound interest, is to ensure you’re giving your savings the potential to benefit from a high interest or return rate.
Unfortunately, the UK national interest rate has been sitting at 0.5% or below for over 5 years. It’s unlikely you will find a standard bank savings account offering much better than this in the current financial climate - some long term savings may achieve better, but your cash may be locked in. Your best bet is to consider alternative options to obtain higher potential returns. he current financial climate. Your best bet is to consider alternative options to obtain higher potential returns.
A few options include:
- Bank accounts with incentives for switching / staying. Some banks offer good deals for becoming a new customer, however the amount of interest you can earn is usually limited.
- Investing money. Investments provide the best possibility for returns, but of course you must remember that your capital is at risk. Learn more about popular investment options.
Compound interest is most likely something we’ve all already benefited from at some point in our lives, potentially without even realising it.
In order to ensure you’re capitalising on the power of compounds, you need to take action and start saving from as early in your life as possible - and most importantly, stick with it!
By doing so, you’re making sure you benefit from the effects of compound gains - not only from now, but long into the future as well.