I ended my last blog post with the observation that ‘Even with the very low savings rates you receive at the moment, the ‘compounding effect’ can make a big difference’.
So what is this compounding effect I was talking about?
Einstein for one, thought it was ‘the most powerful force in the world”
There are two elements to the compounding effect:
• First is the fact that even if you save a small amount each month, over time it will grow into a bigger amount. You are ‘adding to’ and ‘increasing’ the amount you are saving.
• The second compounding effect is that If you leave the interest earned in the account and don’t withdraw it, the interest will start to earn interest itself. Compound interest is “interest on interest,” and will make a deposit grow at a faster rate.
People often say that it’s not really worth saving £x as it’s such a small amount that it won’t make any difference.
It might not seem like much initially but after a while both these compounding effects will have an impact.
If you save £50 each month for a year, you will have £600 at the end of the year.
You have the money saved in a savings account that pays an interest rate of 2%.
To keep things simple – the bank adds interest only once on the balance in your account at the end of the year. So at the end of year 1 you would receive interest of £12.
This is a very small amount but still worth keeping in the account.
So you start the second year with £612.
In year two you continue to save £50 each month. By the end of the year you have £1212.
The interest rate is still 2%. This year you will receive interest of £24.24
In year three you start the year with £1236.24. By the end you have £1836.24 and interest earned would by now be £36.72.
None of this seems like very much and most of us wouldn’t really feel that we were getting particularly rich as a result.
However, if we roll forward to year 10 you would be receiving £131.40 of interest payments and you would have £6701.24 in the account. You would have received £701.24 in interest over that time. Now it starts to sound much more satisfying!