COMPOUND INTEREST - WHY IT IS SO IMPORTANT

Compound Interest - Einstein’s Eighth Wonder of the World
 
What everyone, especially the younger, should know

The following post should not be considered advice; It is purely to demonstrate the power of compounding over time.

 

Einstein described compound interest as "the eighth wonder of the world". He went on to say, “He who understands it, earns it; he who doesn’t, pays it”. 

 

Benjamin Franklin put it another way, “Money makes money. And the money that money makes, makes money.”

 

Every sixteen-year-old in the country should have this drummed into them, and again at eighteen.

 

The more time one gives oneself, the more likely one is to meet their long-term financial target. The target might be to achieve FIRE (Financial Independence Retire Early) at 50 or retire at sixty and travel the world or be financially better off in retirement than one will be on the state pension.

 

By playing with the simple-to-use, calculator above one can see the importance of starting as early as possible.

 

Example 1). A 30-year-old with £500 and saves £100 per month achieves an annual return of 7.0% will have £54,416 at the age of 50. However, if he/she had started at 25, it would have grown to £84,342 and at twenty to £126,767.

 

In the example above, I picked a 7.0% return. That is the typical long-term average from equities. One must be realistic. It is dangerous to put in 20%, see the result and think, "I like the look of that", and then take lots of risks to achieve it. I remind myself that my 17.3% annualised return over the last nine and a bit years has been attained during a generally easy period for equity investing. If I achieve anything like that over the next nine years, I will be happy but surprised. I would, however, be disappointed if I couldn’t achieve 10.0% per annum over the long term.

 

Example 2). Our 25-year-old above does well and when he/she is 30 increases the monthly saving to £250 per month and then at 35, to £400 per month and then at 40, £500 per month. Aged 55, they would have £359,000 and at age 60, £545,000.

 

Example 3). Doting grandparents start a SIPP for one-year-old Sam. They are allowed to put in £2,880; the government adds 25% to that to take it to £3,600. If 7.0% per annum is achieved over the next 50 years, it would be worth £118,008. If they were generous enough to make two further payments on the infant's first and second birthdays, it would be worth £330,695. If the annual return achieved is flexed up to 8.0%, It would be worth £538,000 at age 50 and £1.2m at age 60.

 

 

Examples 1 and 2 are based on investing in an Equity ISA where all capital gains and income are tax-free. If our young people were to invest through a SIPP, then the government would top it up at their marginal tax rate, which would significantly enhance the value of their portfolio. Of course, gaining access to the money in a SIPP is restricted until retirement age. An ISA is much more flexible.  

One should also take into account costs. 0.5% or 1.0% per annum will make a huge difference over time. At the very least, one should be aware of what charges one is paying. 

 

Enjoy playing with the calculator and pass it on!