Compounding – the secret to making money

Compounding: “It’s the eighth wonder of the world: He who understands it earns it, and he who doesn’t pays it.”

Albert Einstein knew that compound interest was the true secret to making money. I’m going to run through how you can earn it and then, hopefully, you will avoid paying it in debt.

How does compounding work?

Compound interest is a financial wonder that allows investors to magnify returns over time. Essentially, it’s when the interest you earn on invested capital is re-invested and then goes on to earn more interest – ‘Money makes money, and the money that that money makes, makes more money!’

Over time, this interest-on-interest approach leads to exponential financial growth. Conversely, it also expands the debt you owe over time so it’s worth bearing in mind on all fronts.

How much growth can compounding achieve?

To demonstrate the phenomenal financial impact compounding can have, it’s best to see how it applies in real-life scenarios.

For this scenario, all investments grow at 7%. I know this is quite an ambitious growth figure, but this is just to provide large enough numbers to effectively emphasise the impact.

Let’s take two investors who have vastly different approaches to their finances – Olivia and James.  Olivia wants to be a financial planner when she is older, so at age 20 she decides to get ahead of the game and begin investing. She invests £100 every month until she is 30. When she reaches her 31^st birthday she then decides to stop saving entirely and leaves the current pot of money to continue growing, until she reaches age 70.

James, on the other hand, is similar to most people I know, and believes that he will earn more when he is older. As such, he decides to put off organising his finances until he reaches age 30. When his 31^st birthday arrives, James then also begins saving £100 each month. However, James never stops contributing – he saves every single month right up until his 70^th birthday.

Now, the results are where these different approaches become quite remarkable. Incredibly, Olivia will have £27,000 more than James on her 70^th birthday. This means that simply by beginning to invest earlier than James, Olivia has made up for almost four decades worth of saving!