Money makes money

Is Compound Interest The Secret To Making Money?

Credit Sam X — Unsplash

Money makes money or so the saying goes. It’s a term that gets bandied about and with a good amount of truth, but don’t think for a second that you need a load of money to begin with. I want to make the case of compound interest, the true hero in allowing you to start with a little and end up with quite a lot more. But before getting into compounding let’s get really clear on what simple interest is first.

Interest is the charge you pay for borrowing money or what you get paid in return for lending it (to a bank/business etc.) So view interest as the rent on money, you pay a rent for using someone else’s when you don’t have enough, and vice versa. Apologies if you knew all that but let’s begin at the beginning.

Say you invest £100 and manage to make a 5% return from interest after a year (and that’s by no means a certainty). Fine, simple, couldn’t be clearer but is a £5 gain really worth risking £100 over? Probably not. But let’s take a longer term view, we’re young and we’ve got time on our side after all.

As you earn interest your overall sum grows (in this case increasing to £105 after a year). With more to your name the amount of interest you can hope to earn in year 2 has now increased. So imagine that £105 returns 5% again, leaving you with £110.25 by the end of year 2.

I want to point out the 25p. This is 25p of compound interest, literally the interest (a 5% return) on the interest (£5) that you earned in year 1. Granted it’s nothing to get excited about but your money is now making money for you and that’s important. Now you’re probably ready to give up if all of 25p is up for grabs, but it’s actually a whole lot more.

When interest gets interesting

Let’s imagine you take that £100 pounds and put it in an ISA (more on ISAs in future) and you also commit to adding another £50 each month on top. That’s like five overpriced gin and tonics, a noticeable amount but also doable on most incomes. Now let’s roll this out over 20 years, assuming 5% returns each year as an average (this is a ballpark, there are no guarantees and in reality you’ll make more on some years than others and occasionally lose money too).

At the end of year 1 you have hopefully made £21 — give or take — , either way that’s pretty underwhelming, much point in carrying on? Yes, there is. Importantly you’ve set something in motion, granted it’s slow but it’s moving in the right direction; notice the interest made in year 2 (£52) is more than double that of the first year.

Roll it forward to year 15 and you’re now making more from interest (£630) than the total of those monthly contributions being set aside (£600). To put that another way your money is really starting to work for you now. By the end of year 20 you will have built up almost £21k overall. £12k of that is your hard earned cash that you have added to your investments over time, while over 8.5k is coming from interest alone.

Now hopefully that’s more interesting (excuse the pun) than the 25p I was going on about to begin with. From a starting point of next to nothing and a reasonable monthly direct debit it’s surprising what can be achieved. Take a look at this compound interest calculator if you want to tailor the numbers for yourself.

If you only remember 3 things, remember these:

  • Pay yourself first

Paying yourself first means committing to that monthly contribution and sticking to it. There are some things you absolutely have to pay each month (rent, student loan repayments), but you need to add your name to that list and make your savings contribution a strict habit. After that you can make guilt free choices and spend the rest however you choose, so go soak up that gin if you want.

  • Plant the tree

Sorry to be a proverb preacher but this is a good one:

“The best time to plant a tree was 20 years ago. The second best time is now.”

The longer you allow your money to work for you, the harder it works. Progress can be painfully slow to begin with but those small contributions make a really meaningful difference over a reasonable period of time, so once the ball has started rolling it often tends to get quicker.

  • The benefit of youth

Not only is it good to have time on your side, the tax man is on your side too. Assuming you earn a small income you won’t pay much tax on it. Putting some of that cash into something like an ISA (a tax free savings account) means that as your wealth builds, slowly but surely, you’ve payed hardly any tax on what ends up being a good amount of money. So consider that a unique privilege of your low paying salary.

If you’re not keen on numbers — honestly neither am I — don’t worry. Just know that the best time to get a handle on your money is now. I’m going to follow up with some more practical ways to do that in future, but that’s definitely enough theory for now.