How To Use Compound Interest To Your Advantage
Though the maths might be complicated, the use of compound interest is simple, making it one of the most powerful tools an investor can employ.
How Compound Interest Works
Compound interest boils down to one simple idea – earning interest on your interest.
Any time that the interest you’ve earned on an investment – from cash in a savings account to share dividends – is reinvested with the original invested sum, you’re compounding your investment.
The interest on the interest means that the amount you earn steadily increases over time.
Unless you desperately need that interest for something else, this is usually the best way to use your interest payments.
Why? Because it maximises the growth of your money. But it can also act against you where debt is concerned.
Timing Matters
Timing is crucial for benefiting from compound interest, in a number of ways. Firstly, it’s important to start early.
Because of the exponential growth that comes with compound interest, early savings grow far more in value.
Here’s the explanation.
For example, there’s someone who saves £5,000 per year in a compound interest account from the age of 18 to 28 and who then stops saving.
He will still end up with more money than someone who saves £5,000 at the same interest rate from 28 to 58.
And that is even though the second saver put in three times as much money. That’s a bit of a mindblower.
The timing of action on the interest matters too.
You don’t start earning interest on the interest until it’s in your account, so pick a savings account where the interest goes in promptly.
Look for accounts with short compounding periods.
These are a measure of how often the interest goes in, from a day to a year.
The shorter the compounding period, the quicker the interest goes into your account.
An account that pays 5% twice a year will earn more than one that pays 10% once a year because you’ll get six months extra interest on the first 5%.
So when picking how to save, a quick compounding rate and low interest may be better than a long compounding rate and high interest.
Comparing Possibilities
Fortunately, the overall effect of this is often reflected in simpler measures.
The Annual Percentage Rate (APR) on an account should show the overall effect not only of interest but also of fees.
The Compound Annual Growth Rate (CAGR) can be used for comparison and planning purposes.
If you’re saving towards a particular target, then you can use the CAGR to work out how much to set aside and how often to do it in order to reach your goals.
A little work with a spreadsheet could remove a lot of uncertainty from your financial planning.
Avoid Compound Working Against You
While compound interest can bring great benefits, it can also cost you. It’s worth paying attention to where it might hit.
Any time the interest on debt gets added to the principle, you’re going to suffer from compound interest.
Why? Because interest starts to accrue on the interest.
If you can avoid this sort of interest then do, and remember to factor it in when making plans to pay off debts, from credit cards to mortgages.
Anything you can do to avoid compounding negative interest, including paying things off sooner, will help.
One step you can take without having to make big debt settling payments is to pay things off in small, frequent amounts instead of waiting to pay a debt off in one big lump.
The sooner you pay off £500 worth of debt, the less time it will spend accruing interest.
So if you start with a debt of £6,000, twelve monthly payments of £500 will leave you with less interest to pay off than waiting a year and paying all that money at once.
Reinvest Earnings
The best way to benefit from compound interest is to reinvest your earnings on investments.
If you’ve invested in a mutual fund, then arrange for your dividends to be paid straight back in instead of paid out to you.
That way, they’ll immediately start earning you more money.
If you’re earning money on stocks or bonds then put the earnings straight back into your investment pool to effectively give yourself compound interest.
Compound interest is a powerful tool.
Paying in quickly and frequently can help with your financial wellbeing, whether you’re investing or paying off debts.
Paying attention not just to interest rates but to the frequency of payments can help you get a better grasp on the reality of what interest will do.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.
