The power of compounding: start investing early
Compound interest can add very substantially to your investments and saving potential over the years. The earlier you start investing, the bigger the gains you stand to make.
In the Age of Austerity, the idea of saving might seem like a luxury which few of us can afford. Low interest rates, stagnating wage growth, and now a weaker pound in the wake of the UK’s decision to exit the EU, all combine to make saving difficult and potentially unattractive. However, by neglecting your savings you are actually losing out on the lucrative potential of compound interest, which could be costing you thousands of pounds in lost earnings every year.
According to a think-tank report from 2011, the average family claimed that they didn’t save because ‘the right savings vehicle does not exist for them’. Interestingly, this same report recommended that a Lifetime Bonus Savings Account might help these families to save more – a precursor to the Lifetime ISA (or ‘LISA’) which was revealed in the 2016 UK Budget.
Today, it has never been easier to save, with tax-free incentives such as the ISAs and Self-Invested Personal Pensions (SIPP) making it simple to put your money to work, particularly in the long term. And the sooner you start, the more you can save.
‘The best way to save is to start as early as possible and saving a little each week or month,’ says Annamaria Lusardi, a leading economist and professor at The George Washington University in Washington D.C. ‘This will add up to large savings down the road.’
What is compound interest?
Compound interest essentially means that you are earning interest on your interest. For example, if you saved £1000 in one year at a compound interest rate of 25%, you would have earned £250 in interest, giving you total balance of £1250. If you did nothing to that money the following year and your interest rate remained the same, by the end of the second year you would have earned another £312.50, bringing your total balance to £1562.50. The following year your balance would be £1953.13, and by year four you will have earned more than £1000 in interest alone.
If you earn simple interest on your savings, and take that money each year, you will make £250 a year on your savings, but the interest won’t compound.
Here’s an illustration of the impact, based on a return of 10% a year on a £10,000 investment with no additional amounts put in:
|Simple interest||Compound interest|
The other factor to consider is that the longer the time-frame, the greater the impact of compound. The message here is start investing early and leave your returns to compound.
How do you find the best rates?
The number one enemy of long-term savings is taxation. Interest from investments is subject to capital gains tax or dividends tax, which can wipe out some of your earnings. So in order to find the best compound interest rates, you need to look at government-approved tax-free wrappers such as ISAs and SIPPs.
You can save up to £15,240 in an ISA account in 2016/17, and in 2017/18 the allowance rises to £20,000. With a SIPP, you can invest up to £40,000 tax free every year, including employer contributions, under the new auto-enrolment scheme.
Within these investment wrappers, you have a surprising amount of flexibility in the way you manage your money. Junior ISAs allow parents to start saving for their children from the day they are born, and regular deposits plus compound interest means that this could add up to a new car or the deposit on a house by the time the child turns 18.
And then there is the increasingly popular stocks and shares ISA, which offers access to investment tools such as Exchange-Traded Funds (ETFs), as well as mutual funds, government bonds, equities, gilts and more. Savers can create and manage their own portfolio and reap the benefits without losing out to taxation or rising rates of inflation. While these investments carry more risk in the short term, over the long-term, stock market returns have far surpassed bank rates. The Bank of England has held the base rate at 0.5% since March 2009, and this has been reflected in the savings rates offered by High Street banks. By contrast, the S&P 500 has returned 8.82% over the past five years (to 28 April 2016). If you had been investing in a tracker fund such as an ETF, your savings would have grown considerably.
Global stock indices including the S&P 500 have surged since 2009
Like stocks and shares ISAs, SIPPS can be invested across thousands of different stocks, shares, and ETFs, so you can either create a balanced portfolio and just leave your money there, or you can channel your inner stockbroker and reshuffle your investments on a regular basis.
With pension funds and savings, it’s all about playing the long game. You won’t make your fortune overnight, but over the course of 20, 30 or 40 years you could build up a sizeable nest egg which includes thousands of pounds of free money – enough to treat yourself to an extended holiday, an early retirement, or a brand new car.
‘Three things will maximise savings over time,’ says Lusardi. ‘Start early, increase the money saved whenever possible, and invest wisely.’
Over time, the smallest investment can multiply in value. It’s not a question of whether or not you can afford to save – it’s whether you can afford not to.