Ten steps to financial freedom: The miracle of compound returns
Filed under: Investing
The Miracle Of Compound Returns
The first step towards wealth is sorting out your finances, and the first step towards sorting out your finances is understanding the miracle of compound returns. Basically, this is about interest, and how earning a slightly higher rate of interest can make a massive difference to the amount of money you end up with in the long run. How does it work, you ask? Like this:
- You earn some interest
- Next year, you earn interest on that interest
- The year after, you earn interest on the interest on the interest
- The year after that... and so on...
With compound returns, interest earned is put into the pot, rather than set aside, which means the pot keeps getting bigger. The bigger the pot of money, the more interest the money earns... and the more interest that gets put back in. Over the long term, this can really add up!
Compound returns are driven by two factors: rate and time.
More than anything else, interest rates determine how quickly and how much your savings grow. The higher the rate at which you invest, the more - and the faster - your savings will grow, which is why you should make every effort to get the highest possible rate. How much does one percent point really matter? You tell us:
|Investment value at these interest rates|
Even small differences in the rate of return have a huge impact on the amount of interest earned in later years. The two percent points between the 3% account and the 5% account yield a difference of over £60,000 after thirty years of saving - that's over £30,000 a percent point! Kind of makes it worth it to shop around for the right account, doesn't it?
Another major factor in the growth of an investment is time - how long your investment appreciates interest. As a rule, the longer your investment sits around and gathers interest, the better:
|Age started saving|
What you should learn from this table: the sooner you start investing, the better. What you shouldn't learn from this table: "I'm forty-five years old and I haven't invested a penny! I won't even bother - it's too late!" No, no, NO. While obviously it is better to start early, late-blooming savers still get some time in the sun, we promise. All we're saying is... well, get a move on!
How much should I save?
The short answer: as much as possible. We've used a figure of £100 for our examples, but don't be put off if you can't afford to save as much. Small sums soon build into bigger ones and you can increase the amount you save each year. The trick, as we've said, is to start saving early and invest steadily in order to get the miracle of compound interest working for you.
A final note on smart saving
Locked-in savings vehicles like bonds and term deposits tend to offer the best interest rates. If you're willing to sacrifice temporary access in exchange for a top rate of return, consider locking your money up for a spell to give it a serious chance to grow.
Step 2: Get control of your money
Step 3: Learn the rules of the money game
Step 4: Dump your debts
Step 5: Make it home sweet home
Step 6: Retire when you want to
Step 7: Invest! Seriously, it's simple
Step 8: Keep the taxman at bay
Step 9: Make your child a millionaire
Step 10: Protect your wealth