The Beginner's Guide to Compound Interest
In this article, I explain the power of compound interest and use an experiment to highlight why you should have started saving for retirement 20 years ago.
“Compound interest is the eighth wonder of the world. He who understands it, earns it... he who doesn't... pays it.”
What is compound interest?
Essentially, compound interest is earning (or paying) interest on interest - the compounding effect. You earn interest on your savings in year 1, but in year 2, you receive interest on both your initial deposit and the interest you earned in year 1.
Compound interest is good for a saver but not so welcome for a borrower. Let me explain with a simple example:
- You initially deposit £100 into the savings account
- The account earns interest at 10% per year, compounded annually (i.e. the payment of interest occurs at the end of the year)
- You save for 5 years and do not withdraw any of your savings throughout this period.
After 5 years, your balance will be £161.05. The total interest earned on your initial £100 deposit is £61.05.
|Year||Opening Balance||Year Interest||Total Interest||Closing Balance|
The calculation of simple interest is slightly different from the calculation of compound interest. The amount of interest paid each year does not change under the simple interest method, i.e. the amount of interest you earn each year does not change.
Calculating the interest element using the simple interest method, you would only earn interest of £10 a year or 10% on your initial £100 deposit. Over 5 years, you would have earned total interest of £50.
Therefore, the "interest on interest" or compounding effect has earned you an extra £11.05 or 22.1%.
Compound Interest on Debt Payments
Compound interest works both ways. Assuming you had been a borrower, i.e. you took out a bank loan of £100. Holding other factors constant, you would owe the bank £61.05 on your initial £100 loan.
10% interest rate on unsecured debt is pretty generous, given credit card interest rates are often much higher, with the average interest rate estimated to be 23.1%. If we were to use the average rate of 23.1%, a £100 balance on your credit card would result with you paying interest of £182.68.
Compound interest is one of the many reasons consumer debts on credit cards are a terrible idea for most people. Payday loans are even much worse. Some big lenders are known to charge interest exceeding 4,000% per year, while others have charged interest over 27,000%.
Benefits of Saving Early
I often hear people saying, "I'm too young to start saving for retirement", despite being in their 30s (or older). I know a 58 year old man who hasn't even bothered with a private pension because he believes the state will look after him in his vulnerable years. Erm yeahh... because the government are well known for looking after each individual right?
Similarly, I hear people saying, "I'll start saving once I start earning more". Not only is time (and compound interest) working against you by further delaying saving for retirement, you're not building up a consistent saving habit earlier on. Deferring saving for retirement until you "start earning more" would make saving more difficult in future, especially as people tend to inflate their lifestyles along with their future earnings. As you'll see, even putting away as little as £25 a month now can go a long way in future.
Another counter-argument to saving for retirement is "Money should be enjoyed, so what's the point saving if you may die before retirement anyway". While I agree with the first part of the statement in that money is to be enjoyed as there's no point in keeping cash for no reason. The second part of that statement is stupid.
Most people in the developed world will live to retirement. If you don't save anything, then you're guaranteed to be poor in retirement. You should be questioning why your retirement plan is hoping you die before retirement? Surely, I can't be the only one who thinks this is ludicrous?
The overwhelming majority of people who do save will enjoy the benefits of their savings in retirement. It is very irresponsible not to save towards your retirement.
Compound Interest Experiment
The best way to explain the benefits of saving early is through a little experiment.
Welcome; Tom, Dick and Harry. They are triplets - sharing the same birthdate. They have the same jobs and earn equal amounts. They all use the same financial institution, each receiving 10% interest on their savings annually.
All aspects of their lives are identical. The only difference being the amount they save each year.
Tom is the most responsible and saves £500 a month from his 25th birthday until he retires aged 65.
Dick is slightly less responsible and does not begin planning for retirement until his 40th birthday. To catch up on lost years, he starts saving aggressively at £1,500 a month, i.e. three times the amount his brothers are saving.
Harry, like Tom, starts saving on his 25th birthday. However, after 10 years, aged 35, he decided to stop saving. He couldn't even tell you what he spent his money on as it was frittered away on trivial items and inflating his lifestyle.
Tom, Dick and Harry save a total of £240k, £450k and £60k during their lifetime respectively.
Before you continue, take a pause to reflect on which brother you think will have the smallest and largest savings at retirement.
Although it may be easier to identify who comes out in first place, I have a feeling you may find it challenging determining who places second or third.
On the retirement date, aged 65, I imagine you would have placed Tom in the first place, Dick in second place and Harry in the last place. You may or may not be surprised by the results.
When all is said and done, Tom, Dick and Harry have total savings of £3.2m, £2.0m and £2.1m at retirement. If you correctly placed the brothers in this order, congratulations, you already understand the power of compound interest and can read my other post on passive investing.
Despite saving half the amount Dick saved in total, Tom ends up with a staggering £1.2m more than Dick with a pretty cool £3.2m at retirement. His monthly £500 savings had been earning interest on interest (compound interest) since he was 25.
Dick's mistake was that he did not start saving for retirement until his 40th birthday. He saved a total of £450k over the next 25 years, and his total retirement pot was £2.2m. Although this amount isn't to be sniffed at, it is significantly less than Tom's £3.2m, despite saving three times as much as Tom each month.
If Dick had saved £1,500 each month from the age of 25 until he retired at 65, he would have ended up with £9.7m at retirement.
Harry only saved £500 a month for the first 10 years, then decided to give up. His total contributions were £60k compared to Dick's £450k and Tom's £240k. As a reminder, Dick was saving 3 times more than Harry each month and saved for 15 years longer.
I'm a generous person and would forgive you if you had expected Dick to have more than Harry at retirement as Harry saved just over 10% of the amount that was saved by Dick. However, Harry still came out ahead.
The only reason for this outcome was because Harry started saving at a young age. Therefore, his savings had a much longer time to compound over the years. At retirement, Harry was able to enjoy the rewards of his early discipline. If he had kept saving throughout the period, he would have retired with the same amount as Tom.
Start Saving Now to Let Compound Interest Work For You
This little experiment has shown that the length of time you're saving for should be considered as, at the very least, equal in importance to the amount you're saving. Don't think you'll make up for the lost time in future when you're earning more as the maths doesn't quite work out like that.
To reiterate, Dick saved 3 times as much as Harry, 650% more and for 15 years longer. However, this was not enough for Dick to catch up on Harry, who saved for only 10 years before giving up.
The lesson here is to start saving as early as possible, irrespective of the amount you can save. You should start young and give up than to start late and hope you can catch up by contributing more.
I hope this experiment has highlighted to you the benefits of saving early. If you haven't started saving for your retirement, you must start today. Do not put it off any longer.
|Begins saving at age||25||40||25|
|Stops saving at age||65||65||35|
|Total saving period||40 years||25 years||10 years|
|Total amount saved||£240,000||£450,000||£60,000|
|Savings at age 65||£3,227,946||£2,020,769||£2,078,376|
You must begin saving towards your retirement as soon as possible. As the Chinese proverb says, "The best time to plant a tree was 20 years ago. The second best time is now."
Understandably, you may not have £500 a month to save now, but amounts as little as £25 or £50 a month can go a long way in retirement as a result of compound interest. Even amounts as little £1 a month to build the saving habit, will result with huge returns over your lifetime.
Some readers may be thinking that they're too old to reap the benefits of compound interest, but that's not true. You're never too old. Dick started saving at 40, yet ended up with over £2m in retirement. It's never too late to start and not starting will guarantee you a mediocre retirement. Don't put off saving for your retirement any longer. Start saving today and your future you will thank you for it.
Remember, be like Tom.
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