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Unlocking the power of compound interest

Posted on 11/07/2018, by Joe Jones

When should you begin making investment plans for the future? And what’s the best way to start investing for retirement? They’re questions many of us put off answering – either for lack of time or because we’re not quite sure how to go about it.

But there’s a real advantage to getting started early, beyond reassuring yourself that there’s a plan in place. It’s also something that can radically improve your chances of realising the best possible returns over the long term. The reason? A small but powerful thing called compound interest.

Compounding the possibilities

We all understand interest in its basic form. Even the technical term is ‘simple interest’. You receive a proportion of your principal investment sum as interest, usually calculated on an annual basis. For example, if you invested £5,000 at 4% a year, you could expect to earn £200 in interest a year.

For many people that is where interest starts and ends: an annual statement from your bank or investment provider that, after a decade of rock-bottom interest rates, is unlikely to set the pulse racing.

But for smart investors, interest isn’t just the outcome, it’s also a powerful tool in its own right. And this is where things start to get interesting. With some investment products – such as our peer-to-peer lending platform, Octopus Choice – you have another option: to reinvest interest earned back into your overall pot.

Do that and you start earning interest on your interest; what’s known as compound interest. It means every year, the amount of interest you earn grows, and over time that growth gets faster and faster. In other words, interest stops being something you skim off the top each year, and starts becoming a catalyst for long term investment growth.

A long-term play

Let’s look at how it can play out over time with the same £5,000 starting sum, earning 4% annually. After five years there’s not a huge amount of difference: you’ll have earned approximately £1,105 with compound interest against £1,000 in simple interest. After a decade the gap starts to open up: compound interest has delivered you earnings of around £2,454 versus £2,000, over 27% more. After 20 years, the gap is over 50% and if you give it 30 years, your interest earnings will be 90% higher.

So compound interest takes time to do its work, but if you’re willing to be patient, it can start to deliver massive returns over the long-term. And the longer you give it, the better it can get.

All of which reinforces the importance of starting early if you want to give compound interest the potential to supercharge your investments. But just how early? The investment bank CLSA conducted research in 2014 that suggested a saver who only paid into their pension during their twenties (and stopped at the age of 30) would end up with a more substantial pot than someone who invested every year from 31 until they were 70 at the same rate of interest. Ten annual payments, made early enough to unlock the power of compound interest, would outperform 40 where the money was given less time to work, the study argued.

And the best thing about compound interest? It can look after itself. With Octopus Choice you’re able to have your interest re-invested automatically, so there’s nothing to do except sit back and wait for the compound magic to do its work. Although, of course, you are putting your money at risk, so it is possible you’ll get back less that you initially put in, and interest is not guaranteed.

Compound interest might not be for everyone, especially those who want to make use of regular returns or want to work on a shorter-term horizon. But if you have the time and the patience, compound interest can be one of the most powerful investment tools at your disposal, as well as being one of the simplest. So, if you’re starting to think about how you plan for retirement or long-term savings, consider letting compound interest do some of the heavy lifting for you. And remember: the earlier you start, the more impressive the returns could be.

Remember, investing places your capital at risk. It’s important you are comfortable with this and know that you could get back less than you put in.