It’s a way of earning ‘interest-on-interest' on your savings. Put simply, that means the interest you earn on your savings, starts earning interest too.
So compound interest may not be top of your lockdown learning experiences but lockdown throws up all kinds of unexpected experiences. I am unexpectedly also trying (trying is the correct word) to be a teacher to my child and we are currently learning about money. Admittedly we are at the very important level of working out how many trains you can buy with pocket money (if I actually remembered to give it to him) but this got onto the subject of how do you afford things when you retire if you don’t have a wage. Aha says I, that is where pensions come in and then hoped I wouldn’t be asked any more questions (I was). Hence a conversation of what a pension is.
- When did I start mine (first paycheck)?
- How do you look after it? (that made me think it is time for a reassessment of my pension so time to check in with a financial advisor)
- Why can there be more money in your pension than you put in? (hopefully but not always – I have certainly watched my pension lose money in difficult financial times but thankfully ultimately gain). Hence, we got onto compound interest.
Now, many people know about this but in an inaccurate poll of people I know most vaguely got it but didn’t really get it. But it is important as it really does explain why starting your pension early pays off. There is no such thing as magic but if there was, compound interest would be the magic ingredient in long term investments.
Compound interest. It's magic
Compound interest is your money earning interest and then you are reinvesting that interest (without having to do anything) so that also earns interest and this accumulates over time. And it works with any amount you put in so even if you can only start small you will still be gaining from the effect of compound interest but the most important thing is to start as early as possible to gain the cumulative effect over the longest possible time.
So in Year 1 you put £1000 into your pension in the year and if we take account of interest only (forgetting any ups and downs of the investments):
Year 1 - £1000 . You get interest of 5% and your pot is now worth £1050.
Year 2 – You put in another £1000 so your pot is £2050. You get interest of 5% which is £102 so your pot is now worth £2152 from you putting £2000 in
and so on and so on………………………… and the earlier you start……
Even Einstein thought it was impressive
For me one of the best things I did in my first 100 days of my first veterinary job was to take the advice of a financial advisor ,(who reiterated the importance of compound interest and what it was), and start a pension. Have a look at this article and head to VetYou.co.uk to start you on the right track with your pension.