In this article, we explain how compound interest works and why it is one of the cornerstones for growing wealth. Albert Einstein called it ‘the eighth wonder of the world’, adding ‘He who understands it, earns it; he who doesn’t, pays it.’
Unlike simple interest, which is calculated just on the principal, compound interest is based on the principal and interest combined. Compounding can significantly increase the value of your investment over time, so it is worth taking the time to understand.
Compounding explained
If you put £1,000 in a bank account which pays 5% interest, after one year you will have £1,050. In year two, without doing anything, you will earn a 5% dividend on £1,050 rather than £1,000.
Over five years, you don’t just get five lots of £50 interest, leaving you with £1,250. Because your interest has been added to your principal, through the power of compounding your total is £1,276.
How 5% interest compounds over five years
| Period | Starting principal | Interest at 5% | Final principal |
| Year 1 | £1,000 | £50 | £1,050 |
| Year 2 | £1,050 | £52.50 | £1,102.50 |
| Year 3 | £1,102.50 | £55.12 | £1,157.62 |
| Year 4 | £1,157.62 | £57.88 | £1,215.50 |
| Year 5 | £1,215.50 | £60.77 | £1,276.27 |
That may not seem much, but if you start with £10,000, £20,000 or £50,000, it can really add up. On £10,000, over five years you will have earned £262 more interest just through compounding (£12,762 vs £12,500). On £50,000, you will have earned an extra £1,314 interest, just through the process of compounding (£63,814 vs £62,500).
Five-year compound returns on larger amounts
| Starting principal | Total interest at 5% over 5 years | Final principal |
| £10,000 | £2,762 | £12,762 |
| £20,000 | £5,525 | £25,525 |
| £50,000 | £13,814 | £63,814 |
Compounding dividends
Rather than sitting on cash and compounding your capital, you can do the same thing with stocks and shares. Let’s do the same exercise with a share with a 5% dividend yield.
If you start with £1,000 and earn a 5% dividend, after a year you can reinvest that £50 and buy more shares. The maths is exactly the same, so in year two you will earn a dividend on £1,050 worth of shares, and so on.
Most investment platforms let you reinvest your dividends for a reduced fee, while some companies offer reinvestment schemes. These are commonly known as DRIPS – dividend reinvestments plans – so have a look on the company’s website.
Exponential growth
In the examples above, we have used consistent interest rates/yields, a fixed compounding frequency and a stable ‘principal’. If any of these variables change, the results will change.
For example, to keep things simple we have assumed interest/dividends are paid once per year. However, in reality, most companies, funds and trusts pay dividends on a half-yearly or quarterly basis.
Reinvesting dividends on a more regular basis results in a slightly higher return than the headline dividend yield. It might be just a small increase, but it all helps to grow your wealth.
The longer your investment horizon, the more time you allow your money to compound leading to exponential growth. Also, adding regularly to your investment can accelerate the compounding process as well as being a good discipline.
Neither a borrower be
In Hamlet, Polonius advises his son Laertes to ‘neither a borrower nor a lender be’ as money often costs friendships. More importantly, when you borrow money you get to experience the downside of compound interest.
As we have seen, £1,000 invested at 5% interest earns you more than 5% due to the power of compounding. The flip side is £1,000 borrowed at 5% costs you more than 5% due to the same self-reinforcing process.
If you borrow money on a credit card and only pay the minimum amount, your debt can multiply. Interest owed and not paid is added to the principal, or ‘capitalised’, so you pay interest on interest.
Borrowing can also magnify investment losses during market downturns. Stock market volatility is often made worse by investors being forced to sell assets to meet debt or ‘margin’ requirements.
Disclaimer: This content is for information only and is not investment advice. Always do your own research before investing. Click here to see full disclaimer.
