Albert Einstein once described compound interest as the eighth wonder of the world. Compound interest has the potential to make you a lot of money over a long period of time, simply by leaving it alone in the right place.
Yes, that’s right, if you put some money aside, in the right place, it can grow more than you may have previously thought.
Sound appealing? Keep reading to find out more.
In this article we’ll explain to you:
- What compound interest is
- How to calculate it
- How it can make you money over time
- The downsides of compound interest
What is compound interest?
Compound interest is the interest of an initial deposit of money plus the interest it gathers over time. This makes the money increase in value faster vs. the interest only being applied to the original amount. Think of it as ‘interest on interest’ or the art of your money making money while you sleep.
How to calculate compound interest
Let’s say you’ve put £100 in an account that gives you 5.116% interest per year.
5.116% of £100 is £5.12 + £100 = £105.12. This would be your total after year one.
But the next year it will be an increase of 5.116% interest on your new amount of £105.12.
5.116% of £105.12 = £5.377+ £105 = £110.497.
You’ve now made £10.497 in two years by leaving your money alone. Now you may think that’s not much money. But this is just after two years and £100. Look what happens if you increase your deposit to £1000 and leave it alone for 10 years.
£1000 at 5.116% interest after year 1 is a total of £1051.16. After year 10 it’s £1647.01. You’ve just made £647 in 10 years by doing nothing.
The more you put in, the higher your returns can be. You can also put in small amounts regularly if you’re not able to put up a large sum at the beginning.
You may be wondering why we’ve been so specific about the percentage. The slight increase from a round number, e.g. 5, happens over time when you take compounding into account.
Another way to calculate compound interest is by using a calculator like this one. It can quickly tell you how much interest you’re likely to earn, all you have to do is enter:
- The compounding period e.g. a day, a month, a year
- The currency
- The amount of money you want to put in
- The interest rate
- If you want to make any more contributions after your initial deposit
How can I grow my money like this?
If you want to grow your money, the first thing you probably shouldn’t do is leave it in your current or savings account.
The interest rates on these types of accounts are often below inflation, hovering at an average between 0.6% and 1.2 %. Inflation is when the price of goods and services increase, decreasing the value of your money. Read here for a more detailed explanation of inflation.
This means your money will lose value each year if you leave it alone in the wrong place. According to the Bank of England, the UK inflation rate was 2.8% between 2000 – 2020.
One thing you might want to consider is using an investment app, such as:
Using these you can put your money in fairly stable investments that can offer up to around 10% annual growth per year.
Before you make any financial decision, be sure to do your own research. Investing in anything means the value of your money can decrease as well as increase. Once you have a good understanding of what you want to invest in, try different platforms, and find the one that works for you.
What are the disadvantages of compound interest?
Leaving your money alone is essentially all you have to do to take advantage of the ‘eighth wonder of the world’. However, this can have the opposite of the desired effect when it comes to debt repayments.
For example, let’s say you borrowed £1000 at a 21.939% interest rate that compounds every year.
Unfortunately, you failed to repay it for three years, now it could cost you more than £1800. 21.939 % of £1000 = £219.39.
The amount you’ll owe in year one is £1219.39, year two will be £1486.91, and £1813.13 in the third year.
This is because compound interest can also work against you if you take longer to pay off debt.
Try to pay off debt as quickly as you can, before you consider trying to grow your money, as sometimes things can change quickly for the worst in business.
The debt you may have had no problem paying off previously can turn into something that can restrict your ability to grow your business.
Compound interest needs time
With compound interest, your best ally is time. The earlier you can start to put money away into an account that pays high interest, the more time it has to compound. This increases the likelihood of you being able to make more money over time.
Compound interest isn’t a get rich quick scheme, and it can take a long time to make what most people would consider a lot of money. Before considering taking advantage of it, remember to think in decades, not months or years.
Keep on top of your finances
Compound interest can be a great way of making passive income.
Once the revenue starts rolling in, you’ll need a simple, reliable app that:
- Helps you keep track of your finances with live profit and loss insights
- Nudges you to record receipts to track your expenses properly
- A wonderful support team that will be there to help you if you get stuck
To get all this and more, find out more about how the Countingup app can help you here.