What is Compound Interest?
Compound interest is the interest on savings calculated on both the initial principal and the accumulated interest from previous periods.
Albert Einstein said, “Compound interest is the 8th wonder of the world. He who understands it, earns it, he who doesn’t, pays it.”
You are 20 years old and want to invest in a pension/retirement account
Say you are 20 years old and decide to invest in a pension/retirement account.
You start with zero and invest £130 (gross)/month for 46 years at 7% return.
By 66, you will have just under £500k in your pension pot.
Total contributions: £72k and Total interest: £425K
- The total contributions of £72k represents 14% of the total pension pot.
- The total interest of £425k represents 86% of the total pension pot.
That is time and compound interest working its magic.
You are 40 or 50 years old with no pension/retirement account
Except, you are reading this, are 40 or 50 years old, have no pension/retirement account and are thinking…..is it too late? What’s the point of investing now?
Do not get disheartened.
There is still a window of investing opportunity. In your 40’s and 50’s you are generally at the peak of your earning power and therefore, have more money to invest.
Example 1
You are 40 years old and open a pension/retirement account, starting with zero.
You invest £585 (gross)/month for 26 years at 7% return.
By 66, you will have just over £500k in your pension pot.
Total contributions: £182k and Total interest: £318K
- The total contributions of £182k represents 36% of the total pension pot.
- The total interest of £318k represents 64% of the total pension pot.
Example 2
You are 50 years old and open a pension/retirement account, starting with zero.
You invest £585 (gross)/month for 16 years at 7% return.
By 66, you will have £203k in your pension pot.
Total contributions: £112k and Total interest: £91K
- The total contributions of £112k represents 55% of the total pension pot.
- The total interest of £91k represents 45% of the total pension pot.
To reach a £500k pension pot at 66, you would need to invest £1,440 (gross)/month for 16 years at 7% return.
Total contributions: £276k and Total interest: £224K
- The total contributions of £276k represents 55% of the total pension pot.
- The total interest of £224k represents 45% of the total pension pot.
You can see that the contributions that a 50 year old must make is £276k vs the 20 year old’s contribution of only £72k to reach the same £500k pension at age 66.
Furthermore, this is almost 4 times what the 20 year old needs to contribute to reach a £500k pension pot and 1.5 times what the 40 year old needs to contribute.
Invest as early as possible to take advantage of the magic of compound interest
From the above example you can see the advantages of investing from a young age. Youth gives you the advantage of time.
The 20 year old has a much greater advantage in terms of investment horizon than the 40 or 50 year old.
Think of it like this:
The 20 year old can stroll to a £500k pension pot.
The 40 year old has to jog whilst carrying a light rucksack to reach a £500k pension pot.
The 50 year old has to run whilst carrying a heavy rucksack up a hill to reach a £500k pension pot.
The later you start, the harder it is as you need to contribute more to reach, (in this example), £500k than if you had started at, say, 20.
Finally, the important lesson is that it’s still doable. You just need to start!
DISCLAIMER: Inquisitive Finance operates on principles of exchange of knowledge, ideas and opinions and learning in the community. Your decisions are entirely your own responsibility, and I am in no way responsible for your actions. I am not a financial advisor. Whilst I strive to provide accurate and up to date information, I make no warranties or representations as to the accuracy or completeness of this information. Use common sense, do due diligence and where necessary, use the services of a licensed financial advisor, before making any financial decision and/or transaction.
