The Financial Snowball: Compound Interest

Following on from my post on identifying where you’re leaking money, today we’ll discuss what’s often referred to as the eighth wonder of the world, that is compound interest.

To cut a long story short and avoid generic examples such as Jack and Jill, compound interest essentially means earning interest on interest. If an investment of £10,000 earns 10% per annum, then in your first year you’ll end up with a pot of £11,000 or a gain of £1,000. Assuming you stay invested and receive the same return on your investment in your second year, you can expect to earn £1,100 as you earn 10% on your initial 10k investment but also on the extra 1k you made from your first year.

No wonder they call it a wonder
No wonder they call it a wonder

 

From the graph, we can appreciate that the earlier years are not very impressive, with the line almost perpendicular to the x-axis. In fact, it takes 18 long years to reach £50,000 but only a further 7 years to reach the next £50,000. If we extrapolate our line, it eventually becomes close to 90 degrees!

If we combine reducing your expenses with the act of compounding, then our investment pot will grow exponentially – the only limiting factor is our life expectancy!

Something to note though: in real life, compounding is still amazing, just not quite as amazing as the above graph. If everyone’s money multiplied by 15 times in 30 years then there wouldn’t be so many problems in our world.

For one, interest rates are absolutely dismal at the moment with the Bank of England base rate being only 0.25%, 1/40th of the above dream scenario. This may fall further and there is worry of entering an era of negative interest where we’re actually required to pay banks to store our money. I didn’t realise that was even allowed – I guess you learn something new every day…

Another point to note is that even if you’re fortunate enough to earn 10%, 10% of £100 is only £10. Compound interest is almost completely negligible in the early stages of accumulating a nest egg. During your early years of investing, the vast majority of your returns will come from aggressive saving.

Finally, compound interest takes a lot of time to start working its magic and you’ll learn the art of patience. The best thing to do is just to focus on increasing your savings rate, as the rest will take care of itself.

But if you’re disciplined and dedicated enough, you’ll too enjoy riding on the compound interest graph, like all the millionaires and billionaires out there.

P.S. I learned everything I know about finance from this book, this book and that oneamongst many others. For a more extensive list, don’t hesitate to drop me a line at rory@ukdoctoronfire.com. If you prefer learning through listening use this link to earn a free audiobook of your choice by signing up to their 30-day free trial. Simply cancel with the click of a button if you decide later on that the service isn’t for you, no questions asked.

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