How compounding can help your returns

What you’ll learn:

• How compound interest differs from simple interest
• Why it works best for long terms savers and investors
• When it can work against you as a borrower.

Investment world legend has it that the physics genius, Albert Einstein, once described the mathematical rule of ‘compounding’ – a vital ingredient for successful, long-term saving and investing - as the ‘eighth wonder of the world’.

Here’s why you should try and harness its power.

How compound interest differs from simple interest

There are two basic forms of interest arrangements for your savings - ‘simple’ and ‘compound’. Both help your money grow but compounding offers the chance to turbocharge your returns – so long as you have plenty of time on your side.

Let’s say (for illustration purposes) you deposit £10,000 in a savings account paying 2% annual interest. Whether your account pays simple interest or compound interest you will see £200 added to your pot after the first year. So far, so what?

Well, you need to be patient. It is in the second year, assuming the interest rate remains the same, and you do not withdraw the interest earned so far, that compound interest versus simple interest begins to reveal its wizardry.

On an account paying simple interest, you will again earn £200 on your original £10,000 balance over the year.

But with compound interest, you not only earn 2% returns on your original £10,000 but also on the £200 interest you left in the account.

This means your savings pot will be topped up by £204 at the end of the second year rather than just £200 – that’s 2% on £10,200 (a total of £10,404)

In year three, the same formula applies. This time you will earn £208 on your balance rather than just £200 – bringing it to £10,612 - that’s 2% on £10,404.

Compound interest works its magic over the long term

You may think these few extra pounds and pence aren’t much to write home about. But the magic of compounding is that as long as you are patient and have plenty of time before you need to tap into your pot, you should see the snowball effect of earning interest on interest as the years roll by.

With our theoretical example of £10,000 saved, the person who earned simple interest of 2% would see £2,000 added to their original balance after 10 years. But the compound saver would have had nearly £2,190 added.

The more time you have on your side the better when it comes to compounding. After 20 years, assuming the same interest, your original balance would rise to £14,859. That’s £859 more than if you had received simple interest.

The same snowball principle applies to money held in investments such as bonds, that pay annual interest, or shares and funds that pay dividends (the share of company profits distributed to investors). Reinvest those returns rather than draw them out each year and you will hopefully see your snowball grow. You can also apply the concept to any potential growth in the value of share prices year on year.

In the real world of course, unless your interest is paid at a fixed rate, your returns can rise and fall. And in the case of investments, the value of your original capital could fall as well as rise. When it comes of dividends, those companies and funds that pay dividends may cut, delay or even cease them in economically challenging periods. On the plus side, many companies pay dividends quarterly or half yearly – so if they do compounding can get to work more quickly.

Also, consider the mathematical Rule of 72 as a rough guide. If you divide 72 by your selected annual interest rate, it will show you the number of years it should take to double your money. In our example, 72 divided by 2 equals 36 years.

The compounding sums in our illustration do not reflect the impact of inflation - the rising cost of living over time, which reduces the spending power of your money. Nor do they take account of any tax you might owe on returns or annual charges you might incur on an investment.

But by compounding the returns you can potentially help your money work harder without lifting a finger.

With a new tax year from 6 April, you can also take advantage of your new ISA annual allowance of £20,000 early and keep your pot out of reach of the taxman. The earlier you start saving and investing, the sooner you could start to earn interest or dividends (so long as companies pay them) and start seeing compounding work for you.

When compounding can work against you

While compounding can be attractive for investors it is important to be aware of the impact if you are a borrower. Annual interest payments on loans will roll up under the same compounding rules, adding interest to interest and snowballing the size of the debt. As Einstein also (allegedly) said about compound interest: ‘He who understands it, earns it; he who doesn’t, pays it.’