Week 4 of a new Monday Money series of blog posts I’m hosting with Emma at EmmaDrew.info and Lynn from Mrs Mummypenny. It’s a great way to share content about money, so do check the links at the end for other brilliant money posts! Plus, find out how to join in if you’re a blogger. We’d love you to add your posts.
If you grasp one concept about money, make it this one.
The killer app that can slash credit card bills, make the most of your savings and leave you skipping off into a mortgage-free future?
I’ve had a bunch of conversations about money with people recently, on issues from mortgage overpayments and pensions for children to annual costs on stockmarket investments and equity release. (Rave on, it’s all excitement round here!)
But the surprise, delight and shock was all driven by one concept: compound interest.
So what is compound interest anyway?
Compound interest is interest on interest.
That’s it. Strange that something so simple can have such a powerful effect.
Bung some money in a savings account. The bank pays you some interest. Cheers!
The next year, you don’t just earn interest on your original savings, but you also earn interest on the interest you’ve already been given.
Following year, you earn interest on your original savings, plus interest on the previous two interest payments you received. Year after, you get interest on your original savings, plus interest on three previous interest payments, and so on. That’s compound interest.
Like a snowball rolling down hill, your savings get bigger and bigger, the longer you keep earning interest on top of the previous interest payments. Compound interest is the population explosion when every rabbit has a bunch of babies, and all their offspring have baby bunnies too, and then all the grandbaby bunnies get in on the action, down the generations.Compound interest is the flux capacitor, that can send your savings and investments accelerating off into the future. Click To Tweet
Keep on going, and your savings balance goes up and up without you lifting a finger. I like that amount of effort.
When compound interest turns bad
So earning interest is great. Paying interest? Not so great.
If you want to borrow money, normally you have to pay for the privilege, as interest on top of the amount you borrowed. To clear the debt, you then have to repay not just the money borrowed but also any interest payments on top. That’s what makes buying stuff with borrowed money more expensive than if you saved up and used your own cash.
Savers get the benefit of compound interest, when they are paid interest on interest already earned, boosting their balance.
Borrowers, however, get hit below the belt by compound interest, when they have to pay interest on the interest already charged on their loan / credit card / mortgage (delete as appropriate).
So while compound interest is brilliant news for savers, it can be damaging for borrowers, if their interest payments get larger and larger. Normally, the quicker you can pay off borrowed money, the less interest you will pay. If the interest is very high however, it can be difficult to afford to clear the interest, let alone make a dent in the original money borrowed.
For borrowers, compound interest is the tornado that can make small debts spiral into enormous problems.
Three levers that control compound interest
Three things send compound interest off into the stratosphere:
- Time (lots of it)
- Interest (lots of it)
So if you’re a borrower, or anyone paying compound interest, and you want to limit the damage – look for the lowest interest rate for the shortest time.
Meanwhile as a saver who will benefit from compound interest, you want the highest interest rate for as long as possible.
In both cases, by upping your payments, compound interest turbocharges the extra money to clear your debt faster and boost your savings higher.
Back in the real world
Compound interest is what makes a huge interest rate, even for a short time, so damaging – think payday loans, and the financial destruction from hideously high interest.
Compound interest is also what makes small payments add up, if you do them for long enough – think pensions, and providing for a comfortable retirement.
Meanwhile as a borrower, compound interest is also what makes smaller monthly payments more expensive. Sounds strange? Well, if you make monthly payments more affordable by taking out a longer mortgage, or spreading car finance over a few more years, you’ll end up paying more interest in total because the interest keeps totting up on a longer loan.
Compound interest can mean that if you buy a fancy pushchair on a credit card, and only make the minimum repayments each month, you could still be paying off the debt when your baby has left school.
If you don’t believe me, let me wheel out the classic Albert Einstein quote. He is reported to have called compound interest “the eighth wonder of the world”, saying “he who understands it, earns it…he who doesn’t…pays it”.
Show me the money
Now I’m quite proud of getting this far through a post on compound interest without hitting you round the head with any numbers.
When talking interest rates, amounts like 15%, 5% or even 0.5% don’t sound very big. They don’t sound like they could make much difference. But when compound interest comes barging into the room, even low interest rates add up over a long time.
So let’s take some examples.
How about a £200,000 repayment mortgage, with an interest rate at 2.5% and 20 years left to run? The payments come to a chunky £1,060 a month. By the time the mortgage finishes, you’ll have paid an extra £54,353 in interest on top of the original £200,000 borrowed.
Cut the rate from 2.5% to 2% – so only half a percentage point – and your monthly payments tick down to £1,011. Saving about £50 a month doesn’t sound so much, but how about £11 grand? Because that small tweak to the interest rate means you end up paying £11,529 less interest by the end of the mortgage.
Taking out a smaller mortgage on a lower rate, and over-paying every chance we had, definitely helped us move to the country. With a bigger debt burden, we couldn’t have struck out for pastures new.
Small tweaks to savings add up too. Everyone bangs on about why it’s worth starting a pension early. That’s because if you pay in £100 a month from the age of 25, it will be worth £208,300 by the age of 67 once it’s been topped up by tax relief and grown at 5% a year after costs. Up your payments every year based on pay rises and bonuses, and it will be worth massively more.
But wait until 45, and those £100 a month payments only generate just over £59,300. That’s more than 70% less. The 45-year-old would need to fork out just under £350 a month rather than £100 a month, to end up with the same pension pot.
I’ve been wrestling with pension calculators this weekend, to get a sense of whether we’re moving in the right direction.
Compound interest means that all those long term savings, like investments and pensions, are hit particularly hard by costs. Even a small cut in costs can make a double whammy of a difference. High costs mean you not only salt away less in the first place, but you also miss out on compound growth if the extra cost had been invested.
If the astute 25 year old invested in a pension with lower costs, so the money grew just half a percentage point more, at 5.5% a year, they would end up with a £238,000 pension pot by 67, rather than £208,000. £30,000 is not to be sniffed at.
The one thing you really need to know about money
So think about your finances. Anything with an interest rate or regular payments – savings, investments, Isas, pensions, overdrafts, credit cards, store cards, loans, car financing, mortgages, the whole shebang – will be affected by compound interest. Change the interest rate, the time and the payments up or down, and even small numbers can make a massive impact. Play around with a compound interest calculator like this one and see what a difference it can make to your financial future.
Harness the power of compound interest, and you’ll see your money shoot skywards. But the destructive power of compound interest can drown you in debts. That’s why I think compound interest is the one thing everyone really needs to know about money.
Now – over to you. What’s your experience of compound interest? Hit hard or seen the benefit? Do say in the comments, I’d love to hear.
Pin for later: