Grow your capital, build your wealth, prepare for your retirement. Whatever your objective, your ally will always be the same: compound interest. They are the ones that will multiply your efforts. If you give them the time. Guided tour and detailed explanation.
With this article, I would like to answer these questions about compound interest:
- how they work;
- what they’ll get you;
- how to use them quickly.
Follow the guide!
Interests: a short definition
You know what interest is. Or you have an intuitive understanding of them.
Interest is the return on a loan, in the form of a periodic payment from the borrower to the lender.
For example, if you take out a home loan, a bank (the lender) lends you money. The bank is the lender, you are the borrower. In addition to paying back the principal, you will have to pay interest as compensation for the service you have been given: lending you money.
The interest is also the gain produced by a financial investment: a Livret A, life insurance, shares, … Basically, it is the same as for your real estate loan. Except that in this case, you are the lender and you are remunerated for the service you provide: lending your money.
The power of compound interest
In the case of a financial investment, there are 2 types of interest: simple interest and compound interest.
A principal earns simple interest if interest is only calculated on that principal.
Take, for example, the case of investing a capital of £100 at an annual rate of 5% simple interest over 2 years.
The interest is easy to calculate. Every year, it will be £100 × (5 / 100) = £5. For a 2-year investment, you double this amount, i.e. £10.
A capital earns compound interest if, at the end of each period, the interest generated over the past period is added to the capital to produce new interest.
Let’s take the case of our previous investment, i.e. £100 at an annual interest rate of 5% over 2 years. But now the interest is compounded
Investment of a capital of £100 at an annual rate of 5% compound interest over 2 years.
For the first year, the interest is £100 × (5 / 100) = £5. These 5£ are added to the capital, which is now £105.
For the second year, the interest is £105 × (5 / 100) = 5.25£.
So, for the 2 years, a total of £10.25.
Compared to simple interest, compound interest allowed a gain of £0.25. This is not huge. But there is nevertheless a gain.
The strength of compound interest is that, where simple interest yields the same gain every year (here, £5), compound interest yields, year after year, an increasing gain.
Compound interest over a few decades
Staying in our example of a capital of £100 at an annual interest rate of 5% :
- after 10 years, simple interest will have brought you £50, compound interest £62,89;
- after 20 years, simple interest will have brought you £100, compound interest £165.33;
- after 40 years, you will have earned £200 from simple interest and £603.99 from compound interest.
Immediately, by increasing the investment period, compound interest is much more interesting than simple interest.
And even then, we remain on an initial capital of £100 without any further payment.
Now let’s imagine that you pay £100 every month:
|Year||Paid-in capital||Interest generated||Total|
|5||6 000||781,37||6 781,37|
|10||12 000||3 436,32||15 436,32|
|20||24 000||16 580,45||40 580,45|
|40||48 000||100 252,46||148 252,46|
And if you pay £200 every month:
|Year||Paid-in capital||Interest generated||Total|
|5||12 000||1 562,75||13 562,75|
|10||24 000||6 872,63||30 872,63|
|20||48 000||33 160,90||81 160,90|
|40||96 000||200 504,92||296 504,92|
It’s not for nothing that Einstein said:
The most powerful force in the universe is the force of compound interest…
How to use this power
So you’ll understand with these few examples: compound interest multiplies your savings and investments.
It would be a real shame to do without it.
The question now is “how do you use the power of compound interest?”
The answer is relatively simple and consists of 3 points …
Open a gainful investment
If you want to take advantage of compound interest, it is necessary :
- to open an interest-bearing investment;
- to feed it regularly.
If you don’t have any, start with a Livret A account. If you have none and are under 25, open a Livret Jeune. You’ll switch to the Livret A later.
If you already have these investments, switch to the advanced options of life insurance and a Home Savings Plan. You should then make sure that you choose the right life insurance (a not too bad return and low management fees) and that you have cash to invest regularly in the Housing Savings Plan (it’s an obligation).
Even if you only invest £50 or £20 per month, it doesn’t matter: do it.
Start saving and building up your investments as soon as possible:
- You’ll get into the habit of doing so;
- you’ll slowly increase your payments.
But start early and quickly. Over time, compound interest will pay off handsomely.
Track down unnecessary expenses
Because the smallest savings are important and will grow, by virtue of the power of compound interest, your savings and your wealth.
In itself, saving £5 per month is not a huge amount. But imagine that by accumulating these small savings, you reach a total amount of £50:
- not just £50 saved from time to time, but £50 saved every month;
- with compound interest, this £50 saved every month will make little ones who, themselves, will make little ones;
- over time, the savings you will be able to make will increase and these £50 saved every month will become £100, £200, £300.
Of course, there is no question of depriving yourself of everything and no longer enjoying yourself. However:
- ask yourself the question of the relevance of your expenses;
- take a closer look at your regular expenses;
- don’t fall into the psychological and emotional traps of money.
Compound interest will allow you to multiply your savings and investments.
The principal is :
- start as soon as possible;
- open a financial investment (a Livret A or a Livret Jeune);
- save regularly;
- switch to advanced investments: PEL, life insurance, PEA, …
If you haven’t already done all of this, do so immediately after reading this article. It’s the shortest route to financial independence and a guaranteed retirement.