Compound Interest; Say What?!

Compound Interest...those two words joined, probably make very little sense to you. Don't worry, I completely understand. Compound interest can either be your greatest friend when saving, or your worst enemy when in debt. 

Albert Einstein described compound interest as the greatest mathematic discovery of all time...so lets get ok with this term. 

Here goes...

The What?

Compound interest is the addition of interest on interest on interest on interest etc, then on the initial amount. Not the clearest, I understand. 

Lets work it through in a calculation. 

Lets pretend I am 25 years old (I wish). 

I start saving £100 a month; over 12 months this equates to £1,200 a year. 

If I save £100 a month, (£1,200 a year) for 5 years, without any interest, my bank account balance will look like this:

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£6,000 in the bank at the end of year 5, after saving £1,200 a year is not bad. 

Now, lets pretend that I put that £1,200 a year in an ISA account. While the average interest rate through 2017 was a pitiful 1%, over the past 10 years, the average annual interest rate was been about 2.25%.  Using that average interest rate, over 5 years I would earn the following:

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The above example broken down very clearly, that's 2.25% interest per year compounded:

  • I apply 2.25% interest to my first year of savings (£27)
  • In year 2, I apply 2.25% interest to my first year of savings (£1,200), the first year of interest (£27) and my second year of savings (£1,200) i.e 2.25% of £2,427
  • In year 3, I apply 2.25% interest to my first year of savings (£1,200), the first year of interest (£27), my second year of savings (£1,200), the second year of interest (£54.61), and my third year of savings.

And so on....

So, in year 5, I have £6,417 versus £6,000 with no interest. Not much I hear you cry? Read on...

...The Magic...

In that example, over 5 years, compound interest earned me an extra £417. Lets extrapolate this over 20 years. Over 20 years, I continue to save £100 a month in my ISA with annual interest of 2.25%. 

If I just save £100 a month, at the end of 20 years, I would have £25,200 in my account. 

Applying annual interest of 2.25%, after 20 years, I would have £32,481 in my account. That's £7,281 of extra money which the bank gives me for free, for putting money into their ISA. 

Now lets pretend I save £100 a month from the age of 25 all the way through to my retirement at 65. Over the 40 year year period, I would have £49,200 of my own money in the bank. With annual interest of 2.25%, 65 year old Wee Scot Finance would have £81,254 in her account. That's £32,054 of interest i.e the banks money. Also known as free money to you and me. 

Lets get a little more excited

£100 a month in savings, when we first start out is manageable. If you can save double, triple or quadruple that amount, think of the amounts you would save. 

This is a form of passive income; I talked briefly about active and passive income in my blog "Lets Earn More Money".

The Flip Side

Compound Interest is a two way street; I can earn interest on savings from the bank, but if I have debt, I have to pay interest over to the bank. Typically, banks charge MUCH higher interest rates on debt than they do on savings accounts. 

What may start as £1,000 debt on a credit card, over the course of 5 years (with 5% interest) can result in me needing to pay the bank £1,276 versus my initial £1,000. While these numbers seem low, compound interest can sky rocket, particularly where interest rates are increasing (as is the situation with the economy at the moment). 

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Finally

If you'd like a copy of the spreadsheet to calculate your compound interest amounts, send an email through to weescotfinance@gmail.co.uk and I'll ping you over a copy. 

Happy saving!

Photo from the beautiful unsplash.com