Today I want to talk to you about the concept of compounding and how compound interest is the corner stone to personal wealth. Without the miracle of compounding – the path to financial freedom and wealth will be near impossible. I hope you will become enlightened and ensure that your money works hard for you, instead of you working hard for your money.
What Is Compounding?
The concept of compounding is the miracle that will make you rich over the long term.
Picture a snowball. If you were to push that small snowball down a hill what would happen? The snowball will continue to pick up more and more snow with every rotation down the hill. This is a representation of compounding and exponential growth.
Compound interest is the process of earning interest on top of your savings or investments – and then earning interest on that interest. This means that if the account in question is not drawn from – the growth will get faster overtime. In other words, leading to exponential growth.
Simply put, this is where your money makes more money that makes more money….
Let’s use a basic example to see this in action.
Say you were to deposit 2000 pounds in to an account that yields 10 percent. During the first year you would receive 200 pounds interest bringing your account total to 2200 pounds. The following year you would earn interest on the 2200 pounds (the interest + your initial deposit). Your interest would now be 220 pounds (10 percent of the 2200 pounds).
Over a longer period of time, lets say 30 years, this would happen without you lifting a finger…
Warren Buffett, arguably the greatest investor of all time, puts his success down to the miracle of compound interest through long term investing.
“My wealth has come from a combination of living in America, some lucky genes, and compound interest.”
Unfortunately the miracle of compounding can also work against you if you are in the unfortunate position of having bad debt. However, today we will talk about the benefits of compound interest and provide actionable steps that you can take today to benefit from compounding!
Why Is Compounding Important?
Let’s use a case study of four people to understand the power of compounding over a 30 year period.
| Jenny | Ben | Marvin | Hannah | |
| Starting Age | 25 | 25 | 34 | 29 |
| Investment Plan | 200 pound a month | 500 pound a month | 1000 pound a month | 500 pound a month |
| Outcome (without compounding) | £72,000 | £180,000 | £252,000 | £156,000 |
| Outcome (with compounding) | £189,739 | £474,349 | £479,912 | £354,938 |
| Power of compounding | £117,739 | £294,349 | £227,912 | £198,938 |
In each case you can see the power that compounding has had on the individuals accounts. It’s safe to say that if you are not utilising compounding you are missing out on a significant amount of growth!
It’s clear from the case above that in order to take advantage of compounding you need to:
- Start as soon as possible.
- Save and invest regularly.
- A little goes a long way.
- Reinvest your profits.
- Once deposited – don’t touch your money.
Do this and I promise you – that over the long term – you will be wealthy.
How Can You Take Advantage Of Compounding?
We will now cover the methods that you can use to take action today in order to make your money start working for you!
SIPP / Employer Pension
Firstly we will cover your workplace pension or your self-invested personal pension (SIPP). This is the number one investment vehicle that you should be utilising in order to take advantage from compounding.
Why should this be your first point of call?
Well, in most cases your employer will provide you with an employer match and if you are not meeting this match – you are essentially giving away free money!
Secondly you cannot withdraw from your pension until you are 55 years old. Unless you have the willpower of a god – this will stop you from withdrawing any money. Your pension provider – unless asked otherwise – will also invest the money for you – meaning you do not need to worry about allocating your money.
Socks and Shares ISAs
Secondly stocks and shares ISAs are a great method to take advantage of your tax free gains allowance. Within these accounts that you can set up with most major banks – you can choose three methods of investing over the long term. You can choose your own individual stocks, investment funds or a hybrid of the two investment vehicles.
High Interest Savings Accounts and Cash ISAs
Thirdly you can utilise high interest savings accounts and cash ISAs. These are standard savings accounts where your bank will pay you interest on top of your account balance at the end of each financial year. It is advisable that you use comparison sites in order to ensure you get the best possible interest rate on the market to get the best return on your money. Unlike the other two methods your money is not at risk (this should by no means put you off the other two methods). However – with every investment there is a risk to reward ratio – the higher the risk the higher the reward and visa versa (in most cases). With this method, do not expect anything over early single figure interest rates – and in some cases this can come close to or below inflation rates! Choose wisely…
Lasting Thoughts
If you are to take anything away from this article to ensure your financial success in the future here it is:
- Start as soon as possible. The magic of compounding needs time – the longer your time horizon – the more money you will have.
- You will have significantly better results with regular saving and investing.
- A little goes a long way. Even with a modest 6% yield your 100 pound invested today would be worth over 5 times as much in 30 years time. Check out our savings challenge if you are struggling to get that first sum of money!
- Reinvest your profits – in terms of investments reinvest your dividends and capital appreciation – this will boost your earnings.
- Don’t touch it! Let your investments have time to grow – you wouldn’t up root a plant before it had blossomed – patience is key.
Now go out and make some money!
Not sure where to start with investing your time and money in assets?
Check out the Invest area of The Long Commute.
Need to free up some extra cash and gain a secure foundation before you start to invest in assets?
Check out the Saving area of The Long Commute.
Need to increase your income and build another stream of income?
Check out the Hustle area of The Long Commute.