Turbo-charge your savings or investments with the power of compounding

Turbo-charge your savings or investments with the power of compounding

With time and patience, compounding can give your saving or investment efforts a massive boost. Read on to find out more about this little-known financial marvel.

When it comes to saving and investing, the key to making serious money is to start as early as you can. Why? Because the sooner you begin, the more time your money has to benefit from a phenomenon known as ‘compounding’ – reportedly once called ‘the Eighth Wonder of the World’ by a certain Mr A. Einstein.

How compounding works

Often known as ‘compound interest’ or ‘compound returns’, depending on whether you’re saving or investing, compounding works a lot like a snowball rolling down a mountain. While we may start off with a small, fist-sized ball, we can end up with something much bigger as it gradually gains momentum.

Here’s how the concept works in practice:

Let’s say you put some money into a savings account. After a year, you’ll have earned interest on that original sum. In the second year you earn interest on both your original capital plus the first year’s interest. Then in the third year, you earn interest on your original capital plus the first two years’ interest. And so it goes on, like a snowball gathering size and speed.

The same thing applies if you’re investing – the difference being that instead of earning interest on your interest, you can earn returns on top of any returns you’ve already earned. Just remember to bear in mind that the value of investments can go down as well as up, and you may get back less than you originally invested. So rather than rolling down the mountain in a straight line, our snowball may have a bumpier ride.

The table below shows how compounding would help a lump sum of £5,000 grow over the course of 25 years:

 

Years


Annual rate of interest/return

2%

5%

8%

0

£5,000

£5,000

£5,000

1

£5,100

£5,250

£5,400

2

£5,202

£5,513

£5,832

3

£5,306

£5,788

£6,299

4

£5,412

£6,078

£6,802

5

£5,520

£6,381

£7,347

6

£5,630

£6,700

£7,934

7

£5,743

£7,036

£8,569

8

£5,858

£7,387

£9,255

9

£5,975

£7,757

£9,995

10

£6,094

£8,144

£10,795

11

£6,216

£8,552

£11,658

12

£6,341

£8,979

£12,591

13

£6,468

£9,428

£13,598

14

£6,597

£9,900

£14,686

15

£6,729

£10,395

£15,861

16

£6,864

£10,914

£17,130

17

£7,001

£11,460

£18,500

18

£7,141

£12,033

£19,980

19

£7,284

£12,635

£21,578

20

£7,429

£13,266

£23,305

21

£7,578

£13,930

£25,169

22

£7,730

£14,626

£27,183

23

£7,885

£15,358

£29,357

24

£8,042

£16,126

£31,706

25

£8,203

£16,932

£34,242

Quite a sight, isn’t it? As you can see, even without any additional money being saved or invested, the snowball effect of compounding means your money grows more and more each year. And given time, even a fairly modest initial investment amount can end up as a large sum of money. 

Please note that the figures above don’t take inflation into account. In 25 years’ time, £8,203, £16,932 or even £34,242 won’t buy quite as much as it would today.

The key ingredient you need

One of the great things about compounding is that you don’t have to be a financial wizard – or a mathematical genius like Einstein – to benefit from its incredible power.

You do, however, need time. The more the better.

As you can see from the example above, even with an annual growth rate of 8%, our initial £5,000 sum would only grow by £400 in year one. But after 10 years we see year-on-year growth of £863. And after 25 years, our money has grown by over £2,500 in just 12 months.

The longer you leave your money to grow, the greater the effect becomes – and the bigger your ‘snowball’ gets.

See for yourself how compounding could help your money grow

Want to know how compounding could help your investments grow? Have a play around with our investment calculator to find out.

Use our investment calculator

Small differences, big impact

Over the long term, the compounding effect means small differences in interest rate (or rate of return, if you’re investing) can have a huge impact on how much money you eventually end up with.

For this reason, it’s worth shopping around when you’re looking for a cash ISA or savings account. Even a 0.5% difference in interest rate can have a big effect if your money’s going to be in the account for some time.

Alternatively, if you’re looking for higher growth rates, you may want to consider investing your money in something like a stocks and shares ISA. Over the long term, investing wisely can help your money grow significantly more than it would in a typical savings account. While savings rates have languished for several years now, it’s not uncommon for certain investment funds to grow an average of 5%, 7% or more.

As we’ve mentioned, it’s important to note that that the value of investments can go down as well as up, so you may not get back as much as you invested. You should also bear in mind that it’s sometimes more difficult to access your money if its invested than it is through a typical savings account. And don’t forget that the higher the returns an investment is capable of, the higher the risk of losing money tends to be.

Start now to make the most of compounding

Whether you’re saving or investing, the phenomenon of compounding can really help your money grow. As we’ve seen above, however, you need to give it plenty of time to allow it work its magic – so if you can, it pays to start sooner rather than later.

As the saying goes, the early bird catches the worm. Or in this case, the returns.

This article is not intended to give advice or a personal recommendation. If you’d like a personalised recommendation based on your circumstances, you should seek financial advice. You can find a financial adviser in your area at unbiased.co.uk

Thinking about investing? You can start an Aviva Stocks & Shares ISA with as little as £50 a month, or a lump sum of £500. The value of investments can go down as well as up and you may not get back as much as you originally invested.

BR01173 04/2016

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