This week our theme is fashion and I was trying to find something fashionable to talk about in the money blog. In the end I picked compound interest because it is so often ignored. Compound interest isn’t a runway model or even the fashion designer it’s more the stage manager behind the scenes doing all the work but not getting the credit is deserves.
So what is Compound Interest?
Compound interest is interest on the interest you received previously. It’s that simple.
But the power of compound interest is leaving the interest on the interest on the interest on the interest etc for years and years and years.
Let’s use my eldest daughter as an example. I mentioned previously that she has a part-time job in a burger chain, and that she has decided to save 10% of her wages. Let’s say she earns £1,000 in her first year, and so saves £100. Let’s also say she put it in a place like shares where shares where the return was 7% per year (these are simplistic figures to explain and inflation or other expenses have not been taken in to account).
If we do the maths it would look something like this:
So, in three years, she would have an extra £22.50 to her original £100, making a grand total of £122.50.
If she left that £100 for 50 years at that rate, it would become £2,945.
Imagine if she put another £100 the second year, then she would have two lots of £2,945. And another £100 on the third year, and so on.
This is the basic concept of Compound Interest. I told you it was sexy, didn’t I? Unlike other things, compound interest delivers. Obviously the only thing we need to do is invest the money in the right place to feel the effects of compound interest, but that is another topic for another day.
This is all a longer part of the conversation with my daughter when we were discussing the 10% rule in the car. It is what makes the 10% rule and all long term savings, like pensions, work.
The compound effect of interest is, I think, key to most of our long term financial plans both for us and for our children. While I might take some financial risks, I don’t want to take any for my daughter. The long term plan is to leave her financially secure; only then can all those other things I want for her in life, like independently living, become a reality.