Considering his work is among the most celebrated and renowned in science, it’s worth listening to Albert Einstein when he describes the ‘most powerful force in the universe’.
Is it light? A black hole? Photons? No – the award-winning scientist was talking about ‘compound interest’ which he called the ‘eighth wonder of the world’. “He who understands it, earns it; he who doesn’t, pays it,” said the Nobel laureate.
So, what is compound interest? How does it work? And how can you make it work to your advantage?
Interest on interest – compound interest explained
When you put money in a savings account, you expect to earn some interest on your money.
For example, if you were to put £1,000 in your savings account at an annual interest rate of 2.4%, you’d earn £24 in interest in the first full year.
However, in the second year, the amount of interest you’d earn would increase, even if the annual interest rate stayed the same. This is because compound interest starts to have an effect.
In the second year, if you left your £1,024 (the £1,000 you deposited plus the £24 interest you earned in the first year) in the same savings account, you’d earn £24.58.
This might not seem like much of a difference, but the impact of compound interest increases over time. It’s also more pronounced when you invest a larger amount.
Using the example above, here’s how compound interest builds up over ten years.
| Year | Opening balance | Yearly interest of 2.4% | Closing balance |
|---|---|---|---|
| 1 | £1,000.00 | £24.00 | £1,024.00 |
| 2 | £1,024.00 | £24.58 | £1,048.58 |
| 3 | £1,048.58 | £25.16 | £1,073.74 |
| 4 | £1,073.74 | £25.77 | £1,099.51 |
| 5 | £1,099.51 | £26.39 | £1,125.90 |
| 10 | £1,237.94 | £29.71 | £1,267.65 |
Source: HSBC
Had you earned ‘simple interest’ at 2.4% – a flat £24 each year – the total value of your savings would be worth £1,240 at the end of ten years. So, compound interest has added £23.65 to your total return.
Compound interest also works for your investments
While compound interest works for money you have deposited in a savings account, it can also work with stock market investments, such as a Stocks and Shares ISA or within your workplace pension.
If the shares you hold receive ’dividends’ (a share of the business profits), you can also reinvest this sum and keep adding to the pot. In other words, reinvesting your dividends can be a powerful compounding tool.
’Coupons’ from bonds can also be reinvested in the same manner. These transactions are usually carried out by a professional investor or fund manager.
Why compound interest means you should start paying into your pension earlier
If you’re looking to save for your retirement, financial advisers and planners will recommend that you start early.
Of course, part of the reason for this is that you have more years to make contributions, and that you’ll be able to build up your pension fund for longer before you start drawing your retirement income.
However, another reason for starting early is the benefits of compounding. As we have seen, you’ll benefit from the returns you are receiving not just on your investments but also the returns these investments have made for you.
Here’s an example. Back in 2017, the BBC teamed up with a firm of actuaries to establish how much an individual would have to pay into a pension to earn a £20,000 income by retirement. Naturally, the results depend on the age you are when you start to make contributions.
Source: BBC
The table shows how much you’d need to pay into a pension at each age to generate a £20,000 income in retirement. The calculations are based on a complex model that predicts the investment return over the lifetime of the pension.
Assuming the pension achieves investment growth of a typical default investment strategy, and assuming the eventual payout increases annually with inflation, as well as granting a 50% income to a surviving partner, this level of saving has a 50/50 chance of providing an annual income of £20,000 or more.
If you start saving at the age of 25 you would need to put away £246 a month, net of tax. When 20% tax relief is added, £307 actually goes into your pension pot. This is only around 14% of the average salary.
However, if you leave it to the age of 35, you will need to contribute £404 per month, equivalent to around 23% of the average salary.
By the time you are 45, if you haven’t started contributing to a pension, you will need to pay in pretty much half of your earnings.
“The biggest message from this analysis is the cost of delaying when you start to save,” says Patrick Bloomfield, partner at the firm who did the calculations for the BBC.
“The challenge is, when they’re in their 20s and 30s people are trying to save, they’re trying to get on the housing ladder, they’re being young and having fun. There are lots of calls on that money.”
Get in touch
If you’re thinking about starting a pension, or you want to have a chat about the arrangements you have already made, we can help. Email enquire@london-money.co.uk or call (0207) 808 4120 to find out more.