Unpacking compound interest
Summary
“He who understands it, earns it. He who doesn’t, pays it.” - Albert Einstein
In simple terms, compound interest is the interest you earn on your interest. Whether your interest comes from a compounded rate on your cash savings account, or from any potential returns on your investments; both can harness the power of compounding.
When investing, your capital is at risk.
Compound interest in action
It’s easy to visualise how compound interest can help build your money over time by looking at the numbers. If you made an initial deposit of £1500 and a monthly contribution of £150 into a Chip Stocks & Shares ISA, here’s what your investment could look like.
These figures include an assumed annual fund charge of 0.40% (fund charges vary).
As you can see, reinvesting your initial returns from year one allows your money to grow exponentially over time, at the same assumed growth rate.
Past performance is not a reliable guide to current or future performance, and should not be the only thing you consider when selecting a fund. Seccl Custody Limited is the ISA Manager for the Chip Stocks and Shares ISA. Fund management charges apply. ISA limits apply. Invest £20k per tax year. Chip does not provide tax advice or financial advice. Tax treatment depends on individual circumstances and may be subject to change in the future.
Why is it so important to start investing early?
The exponential, ‘snowballing’ effect compounding can have on your money, means that time in the market is key.
As your compounded growth is calculated as a percentage, the greater the number of years you can take advantage of compounding, the greater the ‘snowballing’ effect can be.
The table below explains how this looks with the same investment of £1200, with one investment deposited all in one go for a year, the other investment from savings of £10 a month for ten years.
These figures include an assumed annual fund charge of 0.40% (fund charges vary).
The value of your investments can go down as well as up and you may get back less than your original investment. Chip does not provide financial advice. Chip Financial (Investments) Ltd is authorised and regulated by the Financial Conduct Authority, under firm reference number 1005114.
How do I make sure my returns are reinvested?
To understand how returns on your investment are reinvested, it’s important to know the difference between ‘income’ or ‘distribution’, and ‘accumulation’ accounts. You may see these words associated with different funds or investments.
A fund made up of ‘income’ or ‘distribution’ units, could pay out any potential returns on your investment, as a cash dividend. This type of fund is an attractive option for those investors seeking a potential extra income.
However, cash dividends are not automatically reinvested, and if left as cash, can’t harness compounding.
An ‘accumulation’ fund will automatically reinvest any returns into the same fund, automatically raising the value of your investment. The timeframe of reinvestment differs from fund to fund.
By design, accumulation funds seek to promote long-term investment growth, as they create a ‘snowball’ effect seeking to maximise returns.
This is often referred to as ‘snowballing’ as growth can become exponential over time. Continuous reinvestment can also act as a useful buffer against the rate of inflation.
Check out our Stocks & Shares ISA calculator to see how compounding can work on different contributions.
