Can you explain what compound interest is?

People often say that compound interest is the eighth wonder of the world. I just think it’s common sense. In my view compound interest is absolutely key to saving and investing. If you understand compound interest, you will always want to save and hopefully invest.

Unfortunately, compound interest is a bit like the offside rule in football – most people know about it, but not everyone can really explain what it actually is. So, let’s take a quick look at what compound interest looks like in the real world….

For the ease of maths, let’s say you have a £100 investment, and you receive a return of 5% (£5). If you add this £5 to the capital sum of £100 you now have £105. If you then receive a return the next year of another 5%, you will now receive £5.25. Add this to your capital and it increases to £110.25.  5% the next year would be £5.51 and take you to £115.76. However, if you had cashed in your returns, you would have only made another £5 each year – that is the power of compound interest. Lower capital balances mean lower returns. Why would you want lower returns?

Now in my example, an additional 25p, 51p etc may not seem much, but this soon adds up as it increases each year and its money you would be missing out on if you’d cashed in your returns. And don’t forget, when you start to add a few zeros on the end of that original capital investment – a £10,000 investment or a £100,000 investment for example – then things start to get really serious.

Oh, and for those of you that would like to do your own calculations, here is the actual formula. Good luck!