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You've probably heard friends, family and social media finance influencers talk about the 'power of compounding'. Yes, it sounds fancy. But what does it mean? And how can it benefit you?
To put it simply, compounding is the process of earning interest on your interest. The more interest you earn, the more interest you earn - and repeat. Compounding is an exponential formula - which means over time it starts to grow faster and faster.
Our compound interest calculator will let you see the effect in action. Simply input your initial amount, an interest rate, time period, and any additional ongoing contributions you'll be investing or adding. We'll then show you why there's so much fuss about compounding.
Compound Interest Calculator
Results
| Initial Amount | £1,000 |
|---|---|
| Total Additional Contributions | £0 |
| Total Interest | £0 |
| Final Amount | £0 |
What is Compounding?
Compounding is a way to earn interest on top of your existing interest. When you make an investment and earn interest rather than cashing out and taking profits, you reinvest. As a result, your initial investment balance grows with each period, increasing the interest you’ll earn each time. This creates a compounding effect, leading to significant growth.
The key to success with compound interest is patience and a long-term investment mindset. Therefore, if you’re looking for short-term gains, compounding may not be suitable for what you’re after.
Don't forget that compounding can also work against you. Interest on your debt (like loans or credit cards) also usually compounds. Over time, this can cause your debts to inflate well beyond their initial level. Paying off debt to prevent this negative compounding effect might be the right choice for you, depending on your circumstances.
What is the Compounding Formula?
This is the compounding formula you’ll use to calculate potential profits from interest. However, don’t let the formula intimidate you - we’ll break it down and make it easy to understand, even if you find maths difficult.
P * (1 + r/n)^(nt)= A
P is your initial investment (the principal)
r is the annual interest rate. This is expressed as a decimal point and not as a percentage.
n is the number of times per year the interest is compounded
t is the number of years the investment will compound
A is the future value of your investment
To understand this formula better, let's calculate what an investment of £10,000 would look like with an interest rate of 10% over a 5 year period. Also, to make it simple, the investment will compound once per year.
£10,000 * (1 +0.1/1)^(1x5) = £16,105.10
Once we punch in the numbers into the formula, we get our answer of £16,105.10. However, it’s difficult to visualise the significance of compounding interest without comparing it to non-compounding investing. Here’s a side-by-side comparison of what an investment would look like with and without compounding using the same criteria as in our example.
| Time Period | With Compounding Interest | Without Compounding Interest |
|---|---|---|
| Year 1 | £11,000 | £11,000 |
| Year 2 | £12,100 | £12,000 |
| Year 3 | £13,310 | £13,000 |
| Year 4 | £14,641 | £14,000 |
| Year 5 | £16,105.10 | £15,000 |
As you can see with compounding interest your investment would increase by an additional £1,105.10.
Compounding with Monthly Contributions
Rather than placing an initial deposit and leaving the investment over a predetermined term, you can also contribute monthly or yearly. The compounding formula with contributions combines two parts: the compounding formula (your initial deposit) and the annuity formula (contributions you intend to make). Since we’ve gone over the compounding formula, we’ll skip to how to use the annuity formula.
PMT * (1+r)^t -1 / r= A
PMT (Payment Per Period) is how much your intent to contribute each year
r is the interest rate shown in decimal format
t is the number of years you intend to make payments to the investment
A is the future value of the investment
The first part is to figure out what number to use for “PMT”. For the sake of simplicity, let's use our previous example but with the intention of making monthly contributions of £100. Since the interest is only compounded once, your monthly payments will accumulate and not earn interest until the end of the year. Therefore, we can combine all monthly payments into one sum, which would result in £1,200. This is the number you would use for PMT.
Here’s how you would use the formula:
£1200 * (1+0.10)^5 -1 / 0.1 = £7,326.12
Over a 5-year span of investing £100 a month, your investment will increase by £1,326.12 from compounding. Now that we have calculated our compounding interest with an initial deposit and monthly payments, all that’s left is to add both numbers together.
£16,105.10 + £7,326.12 = £23,431.22
So an initial deposit of £10,000 with monthly contributions of £100 over 5 years at a 10% interest rate would result in £23,431.22.
What is Rule 72?
Rule 72 is a useful formula that calculates the estimated time it will take to double your initial investment at any given interest rate.
72 / r ≈ t
r is the interest rate of the investment in non-decimal format, e.g. 10% = 10
t is how much time it will take to double your investment
For example if you wanted to calculate how long it will take to double an investment of £10,000 at 10% interest rate you’d calculate like this:
72 / 10 ≈ 7.2
So an investment with a 10% interest rate would double in roughly 7.2 years.
Compounding Investments in the UK
As a UK resident, you have access to many investments that can benefit from compound interest, such as:
Savings accounts: Many banks offer savings accounts that compound interest daily, weekly, or monthly.
Dividend stocks: Some companies will offer dividends to investors holding shares. These dividends can be reinvested to compound.
Bonds: Bonds are issued by corporations or the government. Essentially, you are lending your money to the issuer in exchange for interest payments. The interest earned on a bond usually compounds every 6 months.
Certificates of Deposit: CDs are a type of savings account with higher interest rates but require a specified initial deposit. The interest generated from Certificates of Deposit compounds on a monthly or quarterly basis.
How Compounding Can Fall Short
Although compounding interest is a great way to build a portfolio over time, there are a few drawbacks you should know about. The most notable negatives of this investment strategy are:
It’s a long-term investment: Compound interest works heavily in your favour if you intend to invest long-term. If you require access to your money or can’t commit long-term, compounding will provide little benefits as your interest won’t build up.
Market changes: If the market you invested in takes a downturn or interest rates change, your investment may not be as profitable as expected.
Inflation: If the inflation rate is higher than the interest rate, then the real value of the investment may decrease over time.
Penalties: Withdrawing before the agreed-upon date of the investment can lead to penalties.
Dependent on contributions: To maximise returns, you’ll want to consistently contribute to the investment monthly or annually. This may not be a possibility for some individuals if they have other financial commitments.
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