The best-kept secret of saving – compound interest
“Compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pay it.” – Albert Einstein
Did you know you’re losing free money?
Yup. Every day. And you don’t even know it. But then why would you? Your math teachers have probably tried to shove it down your throat. But you were doing those silly filters on Snapchat (or maybe that was us). TBH compound interest isn’t going to be of any help to you right now. But, will help your future self!
There can be miracles
Compound interest is a powerful reason to keep faith in saving. Plain old vanilla interest is basically an extra sum earned on your savings with an extra bag of marshmallows on top. Compound interest is when further interest is calculated as a percentage of your savings + existing interest. So what is it, how does it work and how can you get involved?
Interest at work
Banks don’t just want us to borrow money – they need us to save, too. That’s because our deposits are used to lend out mortgages, loans and other forms of debt. So they offer us interest on our savings, which is calculated as a percentage rate (annual equivalent rate, or AER). So if you put £1,000 into a savings account with an interest rate of 3%, you’ll earn £30 in the first year.
Now this is where it gets interest(ing)
At least for geeks like us! 🤓 When interest is added to your savings after the first year – in our example, £1,030 – you’ll then earn compound interest on that higher amount. The interest you get the next year is still 3%. But, because you’ve got more money in the account, the interest earned goes up to £30.90. The balance then grows to £1,060.90. And then interest is earned on THAT amount, and so it goes on…and on…and on!
Ten years later, that initial grand you stashed away would be worth £1,343.92. And that’s not factoring in extra money you add to the account. If you add £200 a year as you go along, the final amount would be a whopping £3,705.48!
£1000 + 3% a year = £1,060.90 after 1 year
£1000 + 3% a year = £1,343.92 after 10 years
£1000 + 3% a year + £200 a year = £3,705.48 after 10 years
Check out this compound interest calculator to see how small savings can add up to big money.
How to take advantage
The magic of compound interest doesn’t apply if you stuff your money under the mattress like this gangster did. As long as you’re saving with an institution that’s covered under the Financial Services Compensation Scheme (FSCS), your money is protected up to the value of £85,000. But your money will only grow if it’s earning more than the rate of inflation.
Inflation is the rate at which prices rise. So if inflation is at 4%, you would need £1,040 to buy the same basket of goods and services that would have cost £1000 this year. If inflation is higher than your savings rate, the value of your money is falling in REAL terms.