What is compound interest?

5 February 2014

Whether you save in a cash account or stocks and shares, your efforts will be enhanced by the power of compound interest. So long as you don't spend your interest or investment returns, that money boosts your original deposit, providing a greater base from which to grow.

So, in year one, an investment paying 5% will pay £50 on a £1,000 deposit, but in year two it will pay £52 because that 5% is being applied to a new bigger balance of £1,050. As each year passes the more your money will grow.

This compounding of interest highlights why it's so important to start saving early. The earlier you start, the less money you'll need to save, as the following example shows.

Simon starts saving when he is 25 and he invests £50 a month for the next 40 years. Steve wants to enjoy his relative youth and doesn't bother starting to save until he is 45. Aware he might be lagging behind he saves £100 a month for 20 years.

Although both paid in a total of £24,000 and achieved a return of 5% a year, Simon has earned £52,618.93 bringing his nest egg up to a total £76,618.93, while Steve only added £17,274.63 to his original investment, giving him a more disappointing final balance of £41.274.63.

Both savers and investors enjoy the benefits of compound interest, but because investors will typically enjoy higher returns in the first place, the effects will be magnified with equity investments.

Some companies pay out dividends to their investors too - and if you reinvest these, you can amplify that compounding effect. Indeed, research from Fidelity shows the impact reinvesting dividends can have on your overall returns. It shows that if you invested a £1,000 stake in newly issued BT Shares on 30 November 1984, by September 2013 those shares would have had a face value of around £3,800; but shareholders who reinvested all their dividends were sitting pretty on a nest egg worth £15,495.



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