In many of our previous blog posts we have discussed how compound interest helps you grow your investments more quickly. We’ve previously noted it as a key benefit of long-term investing for both pensions and ISAs. But what exactly does the term ‘compound interest’ mean, and how does it impact investments? In this article we’ll define the term, giving a worked example. We’ll then look at how compound interest makes your pension and ISA contributions work harder for you.
What is compound interest?
Compound interest may sometimes be referred to as compound growth. It refers to earning returns on not only the amount initially invested, but the previous interest earned too. Essentially it is interest on the interest earned, and is a vital component for long-term investment growth. The longer your funds are invested for, the bigger the benefits you will reap.
Example
You initially invest £20,000 as a lump sum investment. You do not make any further contributions to this investment for the purposes of this example. No withdrawals are made. Your investment earns 5% growth each year*.
Initial investment – £20,000
After year 1 (5% growth) – £21,000
After year 2 (5% growth**) – £22,050
**The growth here is on the new fund total of £21,000, not just the initial investment amount so the growth increases from £1,000 to £1,050.
After year 10, assuming 5% growth each year, the initial investment of £20,000 will now be worth over £32,000!
Note: This example does not take into account any taxes, inflation, etc. It is for illustrative purposes only.
Online calculations are available to help you estimate how interest will impact your investments. The Bank of England savings calculator allows you to incorporate monthly contributions in your forecast too.
Of course, the above example is very simplistic. As noted, it does not consider taxes or inflation, and also assumes a steady growth. In reality, investments can go up or down. Even if growth is achieved each year, some years the growth may be higher than others. Growth may also be calculated on an annual, monthly or weekly basis, which may affect its impact. It’s clear, though, that compound growth in terms of investments, is a positive factor.
The rule of 72
Those investing in pensions and ISAs may look to forecast when their invested money will double. The calculation for this is known as the Rule of 72. In the calculation, you divide 72 by the interest rate.
In our example above, with a 5% assumed interest rate, the initial investment would double in 72/5 = 14.4 years.
At a 2% interest rate, it would take 72/2 = 36 years to double the initial investment.
Again, this calculation assumes no withdrawals, and a steady growth interest rate, and is for illustrative purposes only.
Importance of compound interest for ISAs and pensions
Compound interest reaps the greatest benefit for investors over the long-term. It is an essential component for those investing in ISAs and contributing to their pensions. Both of these are seen as long-term investment opportunities.
This is why our experts advise you to start investing as early as possible. Even if you are only able to commit to small contributions, compound interest can make this money work harder for you. Small contributions can lead to big investment and pension pots over the long-term, thanks in part to compound interest. Of course, the larger the amount you are able to invest, the greater the benefits you’ll reap from compound interest.
Unlike pensions, which have a minimum withdrawal age of 55 (rising to 57 by 2028), ISAs can be withdrawn from. Withdrawn ISA funds remain exempt from both income and Capital Gains tax. However we advise against withdrawing from ISAs regularly, as this has a negative impact on your money’s growth potential. Part of this is regarding compound interest. The greatest benefit can be gained by investing as much as possible for as long as possible. These are the optimal conditions for compound interest.
How Willday Wealth Management can help you benefit from compound interest
The Willday Wealth Management team will help you understand compound interest and how it relates to your individual circumstances. We’ll guide you in building pension and Stocks and Shares ISA investment portfolios that ensure your money is working hard for you. We’ll advise on the best way to grow your investments, including the power of compound interest, and why to consider them as long-term investments. Our goal is to support, advise and enable you to meet your investment goals, and we’ll tailor-make your portfolio to support this.
Call us on 0116 222 0119 or email hi@willdaywm.co.uk to find out more.
*With investing your capital is at risk and you may get less than what you invested
