The power of compound interest

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 that are reinvested after fees and charges.

After the first year you'd have £10,300 - an extra £300 from the 3% investment growth. But that's when compounding kicks in - after the second year, you'd earn 3% on the original £10,000 you invested, as well as the additional £300 you earned in the first year. This would bring your total to £10,609.

After 10 years, you'd have £13,439. Or left for 30 years, and you'd have £24,273. This goes to show the difference time can make.

This example is for illustrative purposes only. It's not a recommendation or based on real life.

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 with interest reinvested after fees and charges, you'd have £116,547 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.

A financial adviser can recommend the best way for you to invest for the future.

Thousands of clients have already taken that first step of booking a financial review, so if you're ready to take control of your finances – book an appointment here.

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