Einstein once reportedly referred to compound interest as the ‘eighth wonder of the world’, stating: “He who understands it, earns it, he who doesn’t, pays it”. So, just what is compound interest and when do you benefit from it?

Whilst financial jargon can often seem complex, compound interest is actually simple and easy to take advantage of. The term refers to the principle that when you save money you can earn interest on not only your initial contributions but on the interest itself. So, if you leave your money in a savings account for an extended period of time, the amount of interest earned can grow significantly. As a result, the rate that your savings grow gets faster.

Let’s say you deposit £1,000 into a savings account that pays 10% interest a year. In that first year, you’d earn £100 in interest. However, if you leave both your initial saving and interest, the following year, you’d receive £110 in interest. The more frequently interest payments are made, the greater the effects of compounding.

The same principle can be beneficial when you’re investing too. Investing returns delivered means they can go on to potentially deliver returns themselves.

Why is compounding so important?

Compounding means that even if you don’t add to savings and investments, they can continue to grow. Over a long period of time, this can lead to a substantial financial boost as interest or returns accumulate. This can be highlighted by looking at how pension contributions accumulate over different time periods.

Let’s say you deposit £2,500 into a pension annually, with investment growth of 5% and charges of 1% each year.

• If you contributed to your pension between the ages of 21 and 30 only, you’d reach 70 with £213,250.  Whilst you would have contributed just £25,000 over a ten-year period, investment returns and compound growth mean it would have grown significantly. 
• If you put off contributing to a pension until you were 30 but did so until you retired at 70, you’d end up with a pension of £228,293. Whilst this is just over £15,000 more than the first example, contributions are far higher at £100,000.
• Paying into a child’s pension also highlights the effects of compound interest. If you contributed during the first two years of a child’s life, a total of £5,000, they’d have £61,947 at 70 assuming the returns and charges above.

The above examples give you an idea of how powerful compound interest is. However, it’s important to keep in mind that they are not an accurate representation, the performance of your pension will depend on market conditions and, as a long-term investment, pension values can fall as well as rise.

When does compound interest matter to you?

As compound interest has the greatest effect over the long term, the impacts will be most felt on the financial areas where you’re looking to the future. This may include:

• Long-term saving accounts
• Pensions
• Investment portfolios
• Savings for children or grandchildren

It can be difficult to calculate the full impact of compound interest, particularly when investing, but there are calculators available online. Simply knowing that leaving interest and returns untouched can boost your savings can help you take advantage of compounding.

Understanding compound interest can help you get the most out of savings. For a comprehensive financial review, please get in touch with us.

Please note: The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation, which are subject to change in the future.