Wouldn’t it be lovely to have your money do all the hard work so that you didn’t have to? When people talk about being financially free, that is exactly what they mean.
So how can my money work for me?
It’s a very simple concept, and one of my favourite financial topics. Compound interest and it’s a concept which the savvy investor understands. It’s simple and it’s POWERFUL.
Albert Einstein is quoted as saying: “the power of compound interest [is] the most powerful force in the universe.”
What is Compound Interest?
Compound interest is interest added to the principal of a deposit, so that the added interest also earns interest from then on.
How does Compound Interest Work?
Yes, that is a mouthful, so here is an example.
Let’s say that you deposit £1,000 into an account this year and the account earns 10% interest per year.
- At the end of the first year, the account balance would be £1,100 (£1,000 x 10%).
- At the end of year 2, the balance would be £1,210 (£1,100 x 10%).
- At the end of year 3, the account balance would be £1,331 (£1,210 x 10%). And so on….
As you can see, the account balance is growing because there is interest paid on the interest earned the previous year. What a great opportunity for an investment to grow faster and faster! It will grow exponentially if you leave it undisturbed.
At the end of the third year, you would have earned £210 by doing nothing, because your money is working for you in the form of compounding interest.
Over a longer time horizon, the difference between leaving the interest to grow vs. withdrawing it can be substantial.
Continuing with Example 1, after 20 years, the balance of the account would be £6,727.50, and after 30 years, the balance would be £17,449. In 30 years, your money would earn £16,449 for you!
Magic! The interest on the interest just continues to accumulate.
I am going to take this illustration one step further.
Now, let’s supposed that you (the investor) continue to deposit an additional £1,000 EACH year in the account, and do not withdraw any interest. For ease of calculations, we’ll again assume a 10% interest rate in the next example.
At the end of the second year, the account will have a balance of £2,210 (£1,100 plus the additional £1,000).
At the end of year 3, the account would be worth £3,431.
After 20 years, if you continue to deposit an additional £1,000 each year, your money would have grown to £69,730, and after 30 years it would be worth £198,392.83. How? Because the interest on your account continues to earn interest too. Wow!
So now you know what compound interest is and its benefits. Whether it is in a savings account or an investment account, in the long run leaving your investment to grow without withdrawing the interest can have a sizeable impact on your account balance.
So it’s time to start saving in order to make the wonder of compound interest work for you.
Saving regularly can have an even bigger impact, and can help you achieve your financial goals much faster. You can read our handy guide on how to save money effortlessly.Saving regularly can have a big impact - it can help you achieve your financial goals much faster.Click To Tweet
Don’t Be Tempted to Spend It
You may be tempted to take the interest as an extra income, or think the interest will not amount to much. In the long run, it is well worth it to leave your money to grow and grow so you can take full advantage of the miracle of compound interest.
The long-term approach of reinvesting your earnings will pay off in years to come, so trade in the current reward of a bit of extra income for the long-term benefit. You can rest easy knowing that your money is working FOR you!
Over to You
How much money can you afford to put away each month? And how much will your savings account be worth if you save and earn compound interest after a year or five years?