A Guide to Compound Interest
In our series of Money Box programmes on The Death of Retirement we talk a lot about the benefits of compound interest. Here's a brief explanation of the concept that Albert Einstein called ‘the eighth wonder of the world’.
“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”Albert Einstein
The concept of compound interest is that interest is added back to the principal sum and then interest is earned on that added interest during the next compounding period.
Looking at our graphic you can see that £100 turns into £105 at the end of year one based on an interest rate of 5%. In year two interest is earned on the £100 capital and the £5 interest from the previous year.
This shows the importance of starting to save for a pension early. Our graphic shows that if you started saving at age 25 and retired at 65 every £100 you saved at age 25 would be worth more than £700 at 65 (based on an annual 5% interest rate).
But if you only start saving at 45 and retire at 65 every £100 you saved at age 45 would be worth £265 at 65 – not bad but not nearly as impressive as the growth over a 40 year period.