With all the issues with interest rates rising and falling over the last few years, if you knew nothing else about them, you’d be forgiven for thinking they’re nothing but bad news! But did you know there’s a way you can make interest rates work to your benefit, potentially giving your savings a boost?
Put simply, compound interest is the return you get for putting your money in a savings account or stocks and shares or trading returns, showing what you might earn over time. The ‘compound’ part might sound a little tricky, but all it really means is the interest you earn on your original deposit plus any interest you’ve earned previously.
If you’re still struggling, then fear not – this post takes a deep dive into what compound interest is, everything you need to know about it and how you can make it work to your advantage.
Want to make compound interest work harder for you? Secure your place at an upcoming STARTrading swing trading course and learn how to grow your wealth the smart way.
What is Compound Interest?
Compound interest is the interest that applies to your deposit plus the interest you’ve earned from previous periods. In other words, it’s earning interest on your interest, like a snowball getting larger and larger as it rolls down a hill.
It can be a powerful moneymaking tool when used to your advantage, helping your deposit grow faster. And the longer you keep your money in the bank, the more interest you earn from it. So, as far as savings and investments go, compound interest is definitely your friend. But if you’re accruing compound interest on debt, you might struggle to pay it off (more on that later).
How Does Compound Interest Work?
Okay, so apart from earning interest on interest, how does it really work? If you’re curious, let’s take a quick look at some of the maths behind it – don’t worry, we’ll break it down step by step and keep things easy to follow. To start, here’s the formula for compound interest:
A = P(1 +rn)ⁿᵗ
| But What Does This Mean? A – Final amount after the investment grows with compound interest (includes both your principal and the earned interest). P – Initial principal, or the amount you start with. r – Annual interest rate, written as a decimal (for example, 5% becomes 0.05). n – Number of times the interest is compounded per year (such as monthly, quarterly, or yearly). t – Time in years that the money is invested or left to grow. |
To give you a better idea of how this works, suppose we invest £10,000 in a savings account at 5% interest. In the first year, we’d earn interest on our deposit, leaving us with £10,500. At the end of year two, we’d earn 5% on our new balance (£10,500), so we’d now have £11,025. By the third year, we’d have £11,576.25, and so on. Say we left the deposit untouched for 30 years, the balance of our savings account would be £43,219.42, which isn’t to be sniffed at!
Simple Interest vs Compound Interest
So compound interest sounds great, but how is it different from simple interest again? As the name suggests, ‘simple’ interest isn’t quite as effective as compound interest. It’s used to work out the interest on your initial deposit only, ignoring any interest you’ve earned. For that reason, assuming the interest rates are the same, you won’t earn as much with simple interest. If we use the example above, after 30 years, you’d “only” have £25,000 – admittedly, a nice, round figure.
What Are the Pros and Cons of Compound Interest?
On the plus side, and as we’ve learnt so far, compound interest can help you build larger returns on your savings over time. Because of this, it rewards those who start saving early. And though it can be a little tricky to wrap your head around at first, online tools (like our calculator) can help to make the sums add up.
That said, compound interest isn’t without its drawbacks. The main downside is that if you’re paying compound interest on a loan, the repayments on which could get away from you quickly if you don’t keep up with them. And if you’re really making the most of compound interest, then you might have to pay tax on the interest you earn, but that problem applies to any kind of interest!
Can You Become a Millionaire with Compound Interest?
Yes, you absolutely could become a millionaire with compound interest, but you’ll either have to invest a large principal or be prepared to wait a very long time to see your balance tip over the six-figure mark. That said, if you’d like to maximise your return on investment, then here are a few tips to bear in mind:
Rate of Return
Perhaps the most important factor in whether you’ll be able to hit your savings goal is the rate of return on your deposit. This is the amount of interest you earn over a period of time (e.g., a year). For most savings accounts, the rate of return is between 4% and 5%, but if you’re prepared to contribute regularly, higher rates are available.
Early Investment
The second factor to consider is when you make your initial deposit. As we’ve mentioned throughout this post, compound interest rewards people who start saving early, so if you’re hoping to retire on your savings, you should start investing as of right now.
Regular Contributions
Making regular contributions is another powerful way of boosting the amount your savings earn. After all, every deposit you make – no matter how small – also accrues compound interest, contributing to your balance.
Taxes
Unfortunately, your savings aren’t safe from taxes, and as you edge closer to £1,000,000, you’ll have to start paying more of them. In most cases, you’re allowed to earn up to £5,000 of interest before you need to start paying taxes, depending on your other income and the tax band you’re in. However, the STARTrading method of trading is tax free in the UK and 100% legal.
Lifestyle
Finally, before you set yourself an ambitious savings goal, you’ll want to consider whether it’s possible in the first place with your lifestyle. Regularly setting aside some income depends on making smart decisions about spending, budgeting and prioritising your future financial security.
Is Compound Interest Risky?
If you’ve made it this far, then you’re probably seriously considering what compound interest could do for you. But what’s the catch? Well, the good news is that compound interest isn’t inherently risky, especially if you’re investing in a traditional savings account. In the UK, savings accounts are covered by FSCS protection up to £85,000, meaning the main risk is inflation eating into the real-terms value of your savings.
There’s usually a greater element of risk involved if you’re offered a higher rate of return. Occasionally, this means locking your money away for a set amount of time or making regular deposits. Though these kinds of accounts aren’t risky in the sense that you’ll lose your money, you do lose some flexibility.
You could see a return above typical savings rates by investing your money in stocks or funds. Unlike savings accounts, there’s a possibility that your return will be less than the amount you put in, so we’d always recommend caution before investing.
Turn Compound Interest into Real Results with STARTrading
As we’ve seen, compound interest can be a little tricky to wrap your head around at first, but once you get a feel for it, you can start making your money work harder for you. Investing early and maximising your rate of return are the keys to greater financial security.
That said, it’s never too late to start investing. Here at STARTrading, we help our clients achieve financial peace of mind using trading as the vehicle. So if you’re sold on the benefits of compound interest – and you’d like to get more from your savings – then you’re in the right place. Secure your place now at one of our upcoming events (we even offer a free trading course!) and get the guidance you need to start investing with confidence.
