Understanding finance

Compound Interest

James Godrich, Research Assistant

Albert Einstein is reported to have called compound interest the eighth wonder of the world, famously remarking, “He who understands it, earns it...he who doesn’t, pays it.”

Compound interest is, simply put, the addition of interest upon interest. For example, if in year one I was to place £10 on deposit, on which I were to receive 10% interest, at the end of year one my total capital would be £11 (£10 principal + £1 interest). 

During year two if I were to continue to receive interest at 10%, I would again be paid out £1 in interest from my initial £10 principal, but now also £0.10 as a result of the £1 interest payment made in year one. My total at the end of year two would be £12.10 (£11 principal + £1.10 interest). 

In order to understand this in practice let’s consider two investors, Plutus and Comus. Both investors plan to retire aged 65 with a £1m pension pot. 

Comus, as the Greek god of merrymaking and festivity, only began saving for this aged 45. In order to achieve the £1m pension pot, assuming interest at 5% paid annually, Comus calculated that he must make annual savings of £30,200 (roughly £2,520 per month). 

Plutus, however, lived up to his name as the Greek god of wealth and started saving for his pension aged 25. Assuming the same interest rate and the same £1m target, he calculated that he must make savings of just £8,280 per year (roughly £690 per month). 

In order to reach the £1m aged 65, Comus was required to make payments totalling £605,000. Thanks to compound interest however, Plutus managed to achieve the same £1m figure by making total payments of just £331,000. 

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