four piles of coins increasing in size

Compound interest has often been referred to as the eighth wonder of the world.

What is compound interest?

When you save or invest the return on your money is known as the interest. Compound interest is the money you make on that interest. It is the interest on interest.

The longer you save or invest the more interest you can make on your interest.

Think of it like a snowball. You start with a small snowball at the top of a hill and as it goes down the hill it picks up more snow. By the bottom of the hill the snowball is a lot bigger.

The bigger the hill, the bigger the snowball at the bottom of the hill. The longer your investment time the bigger your investment could be at the end.

“Compound interest, described in a phrase of disputed origin, is ‘the eighth wonder of the world’. Wonder or trick, it has built great fortunes, and you can use it to get richer.” – Ed Thorp

Compound Interest Example

Imagine you saved £5 a week which is £260 a year. In 40 years you would have saved £10,400.

If you invested that £260 a year at annual rate of 10% you would have £115,074 after 40 years. Thanks to the power of compounding you would have 10 times the amount of money.

After 40 years you would still be earning 10% interest on your money which would be £11,507. You would make more interest in year than the total amount you invested over the 40 years. Amazing isn’t it!

“My wealth has come from a combination of living in America, some lucky genes, and compound interest.” – Warren Buffett

How do you calculate compound interest?

Use my compound interest calculator to help you.

The Rule of 72 is a simple trick to work out how long it will take for you to double your money.

Divide the number 72 by the interest rate. For example, if your money grew at 8% (72/8 = 9), it would take 9 years to double your money.

The mathematical equation for interest being compounded once a year is A = P(1 + r)n

Total (A) = initial Investment (P) x (1+ interest rate (r)) by time (n) squared

“The elementary mathematics of compound interest is one of the most important models there is on earth.” Charlie Munger

When is compounding bad?

When you have money it works for you, when you borrow money it works against you.

If you took out a £1000 loan on a credit card at 18% it might not seem that much. However, if you didn’t pay it back in just 5 years it would have more than doubled to £2,324.

“Compound interest on debt was the banker’s greatest invention, to capture, and enslave, a productive society.” – Albert Einstein

To learn more about investing read our Best Investing Books for Beginners Blog.