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Compound interest is the idea that if you leave money earning a return for long enough you end up with a bigger pot than you fully realise.
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Supposing I take £100 and I invest it at 5%. And I invest if for a year, that will turn into £105.
The mistake you could make is to think you will only ever earn £5, so you take it out and spend it. If you do that the £100 won't grow. You should leave the £100 and £5 interest, and let it work again, because £105 earning 5% the following year, so you're getting interest on interest, will give you £110.25
The key: the original £100 is working and so is the £5.
If you kept going, and stayed invested for 10 years without putting any more in, you would end up with £163 (without inflation), and after 20years, you would get £265.
Over the years, you've been earning interest on interest.
Imagine you did something a little more impressive: aged 14, you invest £2,000 a year at 10% interest, and left the interest, until you were 18years old. And then you don't do anything until you are 65 years old, other than that money you invested between 14 and 18, earning 10% interest, you would have a pot of around £1.2million.
The first point: the earlier you start, the better this works for you.
The second point: the more often you invest, the better this principle works for you.
Take an interest rate of 5%, and if you're earning the £5 at the end of the year, you'll have £105 at the end. But what is the annual equivalent rate, if instead of getting the interest at the end of the year, I'm actually paid it quarterly?
Does that change the effective rate of interest that I'm earning? It does.
The money can start earning interest on interest earlier, so what you would actually do is take the 5% (which is 0.05) and divide it by four, one for each quarter, and add 1, which gives you a rate of 1.0125. The interest you earn with quarterly interest is higher, because each quarter earns interest on interest, so by the end of the year you will be earning an interest rate of 1.0509. Paid quarterly, 5% turns into 5.09% by the end of the year.
If interest was paid monthly, you would end up with 5.12%.
It matters how often you earn interest: the more frequently interest is paid, the greater chance you have to earn interest on interest.
This is great if you are a saver, but it works in reverse if you are a borrower. If you are paying interest, the more frequently you are charged, the worse it is.
Watch out for borrowing arrangements with a higher interest rate, you could quickly end up with a mountain of interest rate to pay.
To finish off: the one other way to make this work for you is with charges.
At MW we keep saying keep charges on your products down. Charges eat your ability to earn money on money.
For example:
You put £100 a month for 10 years into an account that earns 7% gross. If charges are nothing, you will find that £100 a month on 7% annually over 10 years will turn into £17,201. You will have gained £5,201 from earning interest on interest.
If your broker charges you, so you only earn 3% interest because of charges, this will drop to £14,591 total.
If your charges are at 6%, so you earn 1% interest, you will end up with £12,465 total.
Charges really matter, look at what it's costing you to get that money on money return: the higher the charges, the smaller your pot at the end.
The most important things to take away from this video on compounding, the easy way to make money:
1) Don't take your interest out and spend it, otherwise this concept falls apart, same with shares, if you receive a dividend, reinvest it.2) If you're a borrower, this all works in reverse, you're being charged money on money.3) Start early.4) Keep charges down.
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