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Investment: How compound interest can make you money

Einstein called it the 8th wonder of the world. What is compound interest and how does it work? 

“Compound interest — he who understands it, earns it; he who doesn’t, pays it.” ~ Einstein

Getting into the habit of saving is one of the principal elements of financial well-being. Great importance is placed on saving because it’s crucial to generating wealth and obtaining financial independence and security.

Whether it is due to unforeseen circumstances or emergencies, such as a sudden loss of income or unexpected medical bills, people who have no savings put aside could find themselves getting into serious debt to resolve such predicaments.

Furthermore, perhaps the most important reason for saving is retirement — everyone wants to spend their mature years doing as they desire — and it is essential people think about their funds for this as early in their working lives as possible. As such, one effective way to accrue savings is to learn how best to make your money work for you.

So let’s talk compound interest, which Albert Einstein described as “the eighth wonder of the world”. 

By definition, compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods. Compound interest will make a loan or deposit grow at a quicker pace than straightforward interest, which is interest calculated only on the principal amount.

As an example, on an investment of £10,000, which compounds at an interest rate of 8 per cent annually, the saver would earn £800 in interest. With compound interest, the following year the total amount (£10,000 + £800) is taken into consideration. As such, at the end of year 2, you earn £864 taking your total to £11, 664. Then in year 3, a further 8 per cent will be earned on the £11,664 amount and so on.

Consequently, with an 8 per cent interest rate, the initial invested amount will double every nine years. Therefore, the total comes to £20,000 in 9 years, £40,000 in 18 years, £80,000 in 27 years, £160,000 in 36 years, and so forth.

“Compound interest — he who understands it, earns it; he who doesn’t, pays it.” ~ Einstein

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As we can see in this example, as well as earning interest on an initial investment, you receive interest on top of interest. This is why compound interest can make wealth grow exponentially, and why the aspect of compound returns allows your money to work for you.

Compound interest goes in favour of those who start saving as early as possible. Although putting money aside for savings soon into your working life may seem daunting, and a live-for-now attitude can often take over in your 20s, saving early can help you to take a significant step towards achieving financial freedom later on in life. By waiting until later into your career to begin saving, you could stand to lose out on a huge sum.

Furthermore, compound interest can also make a considerable boost when it comes to education fee planning. The key to the power of compound interest is to start saving now — even small amounts add up over a long period of time. Timing is everything and starting early will pay dividends in the future.

Or as Einstein famously said: “Compound interest — he who understands it, earns it; he who doesn’t, pays it.” 

The writer is founder and CEO of deVere Group

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