Say hello to my little friend, compound interest.
I say “little” but do not let that word deter you, because compound interest is one of the most powerful tools we can use in personal finance.
What’s even better is that to use compound interest to your advantage and to serve your own interests, there’s not a lot you even need to do.
What is compound interest?
What is compound interest and why should you care about it?
Some of you may already be familiar with the concept of compound interest. In a previous post I talked about index funds, they generally build wealth using the power of compound interest. But if you’ve never come across compound interest before, he’s a brief rundown.
Compound interest is the name for the ability of your money to make interest on its interest. This leads to a multiplying (compounding) effect over time, hence the name compound interest. A more technical definition is that it is interest on a loan or deposit based on both the initial principal and the accumulated interest from previous periods.
Thinking of it in more simple terms as interest on interest will do fine though.
So you’re interested in interest? That’s interesting!
Let’s back things up for a second.
Whether you are saving money in a regular savings account with your bank, or investing your money in stocks & shares or bonds, you are likely being paid “interest” on your balance. Well you should be. If you’re not earning any interest on your savings or investments we need to sit down and have a heart to heart, but that can wait for now.
The interest is the percentage amount that your money increases by, wherever you are putting it. The reason banks will pay you interest to save with them is because you are effectively lending money to that bank. As a reward for your generous loan, the bank will pay you an interest percentage. Just like you might pay back interest on a personal loan, mortgage, car finance plan, or even paying your mum back that twenty quid you borrowed with an additional bouquet of flowers.
It’s a common and understandable misconception that all money held in a bank is “safe”. When in reality, if everyone decided at the same time to withdraw all their savings from a particular bank, that bank would most likely not be able to pay everyone “their” money back. This type of situation is sometimes referred to as a “run on the bank”.
The reason I’m stressing this point about the risk of saving in a bank is because many people are put off from the idea of investing because it is too “risky”. Yet at the same time, these same people aren’t fully aware of the risks involved with lending your savings to a bank. The banks don’t pay you an interest rate as a gesture of goodwill, they do it because they are investing your money elsewhere and making a profit from your loan (i.e. your savings).
Why you should care about compound interest
Okay, so compound interest sounds like a reasonable concept but why should it matter to you and your finances?
Often the power of compound interest over time is referred to as “the magic of compound interest”. The word magic is used because the effects of compound interest can look surprising or even unbelievable to most people.
Compound interest has the power to make a minimum wage worker a millionaire.
A bold statement, but it’s true. Compound interest coupled with its best friend time (I’m sure you’ve heard of him), has the power to make even the most meagre investors extremely wealthy.
Show me the money!
I’m well aware that so far, I’ve talked a lot. For anyone who’s new to compound interest, what will really convert you is to see its magical power in action.
So let’s run through a simple calculation.
Our example subject is Jane, she is twenty years old and earns minimum wage in the UK in a full-time job.
Yearly Net Salary (After Tax): £15,201.80
Savings Rate: 13.8%
Investing Figure: £175 per month
Investing Method: Index Fund
Investment Return Rate: 9.8%*
Investing Period: 40 Years
*To keep this simple I’ve used an S&P 500 index fund which has had a historical average rate of return of 9.8%.
Final Investment Portfolio Total: £1,050,029.07
By investing early and with just £175 per month, Jane has managed to become a millionaire by the time she’s 60, purely thanks to compound interest. Well done Jane.
Over this 40 year period the actual amount of money invested by Jane was only £84,000 (£175 x 480 Months) and yet because of the power of compound interest, Jane’s investments were able to generate £966,029.07 over her investing lifetime!
This may sound like crazy witchcraft, but I assure you it’s not. The amazing thing about compound interest is that given enough time, the interest you earn has the power to multiply exponentially. Changes to your investment rate of return and also the amount you are able to save (savings rate) will affect how quickly your money grows.
Obviously this is a simple calculation and doesn’t take into account factors like inflation, but it also assumes that Jane will never make anything more than bare minimum wage in her whole lifetime (which is unlikely).
There are numerous variables during one’s lifetime that will either help or hinder your ability to invest and build wealth. But on a basic level I hope this shows financial freedom can be achieved without having to live off beans on toast for the rest of your life, or be selling your soul to earn corporate megabucks.
Negative effects of compound interest
I’m sure to you this all sounds great, but you must also be thinking “what’s the catch?”.
Like with anything, for every upside there must be a downside. Compound interests’ downside may not be what you would expect though. The negative side to compounding is that just like it can work in your favour to build wealth, it can also work against you to destroy your progress.
If we kept everything in our calculation above the same, but instead of earning 9.8% Jane only earns 7.8% on her investments because the company she uses charges a 2% fee. Her total investment at the end of the 40 years would only be £580,410.62! That small sounding 2% fee has cut her portfolio almost in half and stopped her from retiring as a millionaire.
This is why it’s really important to make sure you invest in index funds with low costs (expense ratios) like Vanguard’s because a couple of percentage points can make a whole lot of difference over time.
I strongly believe that it’s worth learning to invest yourself rather than use a financial manager who will likely charge a 1-2% recurring fee on the value of your whole portfolio. The impact of these seemingly small percentage fees and costs can be so damaging to your ability to build wealth over time. To be perfectly frank with you, it’s a big reason that put me off becoming a financial advisor with a company. It just doesn’t sit right with me that I’d be lining my pockets from a customer’s investments; when for the most part, it’s perfectly manageable for someone to control their own portfolio with just a little guidance.
I hope this has been useful in teaching you some of the amazing work that compound interest can do to help you reach financial independence.
One of the most important takeaways I want you to remember is that compound interest works best when it’s given time to breathe. So if you want to utilise compound interest to its absolute full potential, get investing sooner rather than later.
Take a look at this compound interest calculator and play around with the settings to see just how it can change your life.
With time on your side, you really can grow your wealth beyond what you’d even believe to be possible.
Don’t sit around, the clock is already moving.