“Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn’t, pays it.” Maybe Einstein actually uttered this quote attributed to him, maybe he didn’t. Who cares – what matters is it really is true.
Put simply, compound interest works like this. You have some money. You save or invest it to earn a rate of interest. This interest is added back to the principal sum, making it bigger. You keep the new total – the starting amount plus the interest – invested or saved. You earn interest on that – more, in fact, because you are earning it on the new total. So your pot gets even bigger.
And this happens the next time, and the next time, and the next. That’s the power of compounding.
But that’s not all. To experience the most power from compounding, you need a magic ingredient – time.
Analysis from Fidelity International reveals investing earlier in your life can generate a savings pot worth 75% more compared with those who wait until years later, due to the power of compound interest.
The investment company ran calculations to compare two hypothetical investors’ investment habits and account balances after several decades. It revealed the shocking truth about compounding – investing earlier could mean investors who contribute less to their portfolio still end up better off in the long-term.
This is what happened.
Investor A, “Early Bird”
Early Bird invests £1,000 a year into the stock market between the ages of 18 and 38. This gives them a pot worth £30,620.
Even if they contributed nothing further, by the time they reached age 65 the phenomenal power of compound interest would see their original investment grow to £86,026.
Investor B, “Wait and Be Late”
Wait and Be Late decides to begin their investing journey at the age of 38. They save £1,000 a year until the age of 65, meaning they contribute £8,000 more than early Bird.
But by the age of 65 their overall pot stands at £49,205 – more than £30,000 less.
Source: Fidelity International, September 2019. Based on assumptions of annual growth of 5%, and applying service fees of 0.35% and ongoing charges of 0.75% (i.e. annual growth minus fees of 3.9%).
Tom Stevenson, investment director for Personal Investing at Fidelity International, said: “Compound interest is an extraordinarily powerful force that anyone saving or investing for their future should understand.
“The power of compounding can turn small but consistent financial commitments into a considerable amount of money after a few decades.
“As our calculations show, the important factor here is time. It is the main component of compounding, and the reason why people should start to save as soon as they can.”
Furthermore, key to compounding effectiveness is keeping fees low so more of your money is being invested over time and not being depleted in excessive charges.
The lessons are clear. Start as early as possible, allow for time to work its magic and keep your costs as low as possible.
While this might seem like something of a challenge, taking advantage of compounding could set you on the road to achieving your financial goals later in life.
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