Einstein once called compound interest “the eighth wonder of the world” saying that “those who understand it, earn it, and those who don’t, pay it”. But what is compound interest and how can you make it work for you?
In simple terms, compound interest is ‘interest on interest’. When interest earnt on your investment gets added to the capital and the total amount begins to accrue interest. Not only are you earning interest on your initial investment, but you are getting interest on top of the interest you’ve earned.
So, if you invest £10,000 at a rate of 8% per annum, in year one you will earn £800 in interest. If you don’t touch that interest and leave it as part of your investment, by the time you get to year 3, that will have turned into £2,597.12 in interest alone. Fast forward to year 10 and you’ll have racked up £11,572.34 in interest, more than doubling your original investment. The table below shows you the snowball effect that compound interest can have on your wealth versus removing the interest over a 10-year period.
Getting the benefits of compound interest isn’t a quick win. This approach requires a long-term commitment to savings and investments, meaning that it’s best to start early. It’s not surprising that many financial planning and retirement experts recommend applying this approach to a retirement plan. A 20-year-old who invests £5,000 in a one-off investment that earns an average 8% a year will have accrued £160,000 by the age of 65. When you compare that to a 39-year-old who invests the same amount, they would only have £40,000 at 65. Of course, the benefits are even greater if you continue to make regular contributions to your investments.
Is the interest rate important?
When it comes to compound interest, the answer is very. Just 1% difference over the course of 10 years (7% vs 8%) could mean you earn almost £2,000 less on a £10,000 investment. This means it’s important to shop around to find a good rate whilst bearing in mind the amount of risk you are willing to take with your money.
How can I make it work for me?
When investing on Propio, the majority of interest payments will be paid back when the investment comes to an end. Whilst it can be tempting to put your earnings towards your summer holiday or that new pair of shoes you’ve been lusting over, reinvesting your original capital plus interest can be a great way to start building up your nest egg and planning for a more secure future.
As with all investing, your capital is at risk and your investments may go up as well as down.