The power of compound interest

Why a simple law of mathematics means investing more, and sooner, could help you realise your long-term financial goals

From buying a first home to starting a family, our personal finances can be pulled in countless directions when we’re young. When it feels like there are more pressing ways to be spending our money, it can be hard to prioritise our financial futures.

Yet starting your investment journey early could pay off later in life, as the sooner your money is invested, the more opportunity it has to grow. And this is down to something called ‘compounding’.

Compound interest is no gimmick or complicated bit of financial wizardry, but is instead a basic law of mathematics.

It works as follows. When you set money aside and receive interest in return, you’ll earn interest not only on your initial amount, but also on the interest that has been added to it already.

In short, you earn interest on your interest – an effect which snowballs, or ‘compounds’, over time.

When it comes to investing, there’s of course no guaranteed rate of interest and you could get back less than you paid in. But as an example, if we assume that the value of investments rises over the long term, even if only in line with inflation, this compounding effect can be very powerful.

The more you invest, and the better your investments end up performing, the greater the possible effect of compounding.

Another factor that influences the power of compounding is time.

If your money is going to be invested for decades, rather than just a few years, it stands to reason that the potential effects of compounding could be much greater.

For this reason, retirement savings that are put away in your 20s and 30s have much more opportunity to grow than money put away later in life.

Let’s look at a simplified example:

A £10,000 lump sum is invested with average returns of 3% a year, after fees and charges, that are reinvested.

Invested for 10 years, this £10,000 becomes £13,439. The effect of compound interest here contributes £439 to the overall gain. Invested for 30 years, though, this £10,000 becomes £24,272, with compound interest contributing £5,272.

Whether you’re starting to invest for your own future, or if you’re looking to help a loved one by laying the foundations for their long-term financial well-being, don’t be intimidated by the scale of the challenge.

It doesn’t matter if you’re starting small. Even a relatively modest monthly investment could, over time, grow into a larger sum than you might’ve imagined.

Setting aside £200 a month might not sound like a lot, but if we again assume average returns of 3% a year, after fees and charges, with interest reinvested, you’d have a pot worth £116,838 after three decades.

This is just an example – investment returns can never be guaranteed and you may get back less than you invested – but it illustrates the potential that compound interest has to help you realise your long-term financial goals.

If you’d like more information on ways to invest for the long term, you can find an adviser in your local area here.

The value of your investment can go down as well as up so you might not get back the amount you put in.