So, what is it exactly?
Compound interest has been called the eighth wonder of the world. We cannot verify whether that is true—we are pretty sure some governing body of the United Nations has to vote on that—but it’s a really good way to watch your money grow while doing nothing.
Simply stated, compound interest is the principle by which the interest you earn also earns interest, and the interest on that interest earns interest, ad infinitum. The larger your balance gets, the bigger those interest numbers become.
Here’s how simple interest and compound interest compare—in this example you have £100 in the bank and your interest rate is 5% per year. First, simple interest:
Year 1: £100 + £5 = £105 (£5 in interest)
Year 2: £105 + £5 = £110 (£5 in interest)
Year 3: £110 + £5 = £115 (£5 in interest)
Now compare that to compound interest, with which the interest you earn also earns interest:
Year 1: £100 + 5% = £105 (£5 in interest)
Year 2: £105 + 5% = £110.25 (£5.25 in interest)
Year 3: £110.25 + 5% = £115.76 (£5.51 in interest)
What are the pros?
The biggest benefit of compound interest is that you make a lot more money than with simple interest. In fact, there’s something called the Law of 72 that says that the number 72 divided by the annual interest rate is the amount of years it will take to double your money without ever adding another penny. If your interest rate is 5% (as in the example above), it would take you something like 14 years to double your money.
The earlier you start saving in a compound interest account, the more advantage you get. As the numbers get bigger, so does the benefit of compounding. Think of it like a snowflake turning into a giant snowball—the longer the hill is, the bigger the snowball can get.
The other factor is how often the interest is compounded, or added to your balance. The more often the money is compounded (some types of accounts compound monthly or even daily!), the faster it grows.
Is there anything to be careful about?
Compound interest is rainbows and puppies when you are earning interest, but it’s whatever the opposite of rainbows and puppies is if you owe money.
Credit cards are a great example of how compound interest can work against regular people. Assuming that you never pay your bill (which would never happen, right financially responsible people?), here’s what would happen:
Year 1: £10,000 + 20% interest = £12,000 (£2,000 in interest)
Year 2: £12,000 + 20% interest = £14,400 (£2,400 in interest)
Year 3: £14,400 + 20% interest = £17,280 (£2,880 in interest)
Within three years, the amount of money owed to the credit card company is almost double the original balance.
So to review: Compound interest is great if you’re earning, terrible if you’re owing.