What is compound interest?
Compounding, or compound interest, refers to the principle that when you invest, as well as earning interest on the investment, you also earn “interest on the interest”. This means that not only is your money growing over time, but the amount you earn each month grows in value as well.
Understanding the value of your money over time, and the exponential growth created by compounding, is essential for investors looking to optimise their income and wealth allocation.
What are the benefits of compound interest?
Compound interest can be a potent factor in wealth creation when it comes to your investments. Growth from compounding interest is also important in mitigating wealth-eroding factors, such as inflation and the increasing cost of living.
The graph below helps to demonstrate the miracle of compound interest, famously regarded by Einstein as the “Eighth wonder of the world. He who understands it, earns it... he who doesn’t... pays it.”
The graph shows the result of £5,000 invested in BondMason or a similar investment fund over 20 years at a net interest rate of 6%. The principal figure of £5,000 is the blue line. The orange line shows the result of 6% interest without compounding. So, if you withdrew your monthly interest earned, you would earn £6,000 interest over a 20-year period. Finally, the grey line demonstrates the benefit of compound interest over 20 years. Hence, by re-investing your interest, you would earn £11,035.68 interest over the same period.
The rate at which compound interest accumulates also depends on the frequency of interest payments. If the interest period is bi-annual, quarterly or monthly, then the total amount of interest paid across the year will be higher than if it is calculated annually. This is because interest is being paid on interest accumulated in those smaller periods. The more frequent the compounding periods the higher the resulting growth value.
Doubling your money
So, if you leave your money invested, it will continue to accrue interest and earn interest on your interest. What is interesting, excuse the pun, is the time it could take to double your money.
What is the formula for calculating compound interest?
The rule of 72 helps to calculate this. Formula below:
If you were earning 6% interest, it would take approximately 12 years to double your investment.
As the interest rate is the denominator, small changes can have a big impact. If your target return is 4%, then it would take twice as long (25 years).
The long-term view
In a world that has become increasingly short-term in its view, compound interest is one phenomenon than demonstrates the power of the longer term and its importance to successful investment strategies.
For simplicity’s sake, assuming a return of 6% per cent a year: if you invested £10,000 you would receive £600 in year one, £636 in year two (6 per cent on £10,600) and so on. Therefore after 40 years you could have a pot of over £70,000. However, if you chose to spend £10,000, on say a holiday, the longer-term impact is considerable. By removing this money from the compounding process, it could cost you over £30,000 over 20 years. This again emphasises the benefit of reinvesting income and dividends.
What does it mean for you?
“The best time to start investing was 20 years ago. The second-best time to start investing is now.”
It may sound obvious, but with one in seven British adults retiring last year without a pension, it’s something that is a very real issue that needs to be addressed.
Many people are starting to save much later in life, and the consequence is they will have a huge financial shock when they get to retirement age with low levels of saving, living far longer than perhaps they expected. To avoid this, you need to be saving and investing from a younger age than you may have first thought.
Investing requires a certain level of knowledge and expertise. When considering where to invest money, you need to understand the importance of a diversified investment portfolio, have an appreciation of investment timeframe, and be aware of things such as liquidity and the trade-off between risk and return.
How BondMason can help
Since 2015, BondMason has achieved a stable and steady investment track record. Our clients have achieved average net returns of 6% p.a, investing over £50M across from a conservative loan portfolio secured against UK property.
- Diversification: Clients can easily access returns from a broad selection of loans and lenders, in just a few clicks.
- Easy access to funds: We understand that circumstances may change. With BondMason Core it is good to know that you are typically able to liquidate your investment and withdraw funds in a few days.1
- Portfolio in your pocket: The online dashboard is easy to use on any device, so clients can monitor their investment performance anytime.
- Real people: Our team are always at the end of the phone or email to answer any questions. We value client feedback and are always happy to hear how our service can be improved.
BondMason Core has been recognised as providing one of the highest quality offerings on the market, achieving the maximum Defaqto rating of 5 stars2.
We’d be happy to answer any questions you have about BondMason. Please contact us on 01582 802 000 or email the team at firstname.lastname@example.org
Your capital is at risk. Past performance is not guide to future performance. The value of your investment and the income from them can go down as well as up, and you may get back less than you invested.
1 Liquidity is not guaranteed and it may take longer to liquidate your holdings. BondMason is not covered by the financial services compensation scheme or regulated by the Financial Conduct Authority.
2Defaqto 5 Star Rating applies to BondMason Core only.