What is compound interest and how does the magic work?

July 21, 2022

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Reading Time: 6 mins

If you’ve already started investing, you’re probably familiar with compound interest. But, if the concept is new to you, prepare to have your mind blown.

Compounding returns is the secret ingredient to building long-term wealth and I’m going to tell you exactly how it works. More importantly, I’ll share some tips on using it to your advantage with your investments.

Keep reading for all the details or click on a link to jump straight to a section…

What is compound interest in simple words?

Simply put, compound interest is when you earn a return on your money and you continue to earn interest on that interest.

You might be thinking, what’s all the fuss about?

Well, this seemingly insignificant concept was allegedly referred to by Einstein as the ‘eighth wonder of the world’.

Have you ever wondered how the rich stay rich and how wealthy people just seem to attract more money?

A big reason for this is compound interest.

the chess board allegory

There’s a famous story that illustrates the extraordinary power of compound interest (once described by Albert Einstein as the 8th Wonder of the World). You can find it here:

It goes:

Legend has it there was an Indian King who was obsessed with chess. The King held his own skills in rather high regard, and often bested the scholars in his realm in friendly matches.

Whenever a new traveller entered his kingdom, he would challenge them to a game, and if they beat him, he would reward them with any treasure or prize they desired.

One day a pilgrim wandered into his land and was challenged to a game by the King. What the King didn’t know is that our pilgrim friend was actually a chess grandmaster and had been playing his whole life. When asked his terms, he modestly requested: “Your Highness I would simply like a single grain of rice for the first square and then for each corresponding square to double the last”. The king laughed and agreed to these measly terms.

The pilgrim went on to beat the king in impressive fashion and left the crowd gob-smacked. However, although stunned, the King stayed true to his promise and acknowledged that the pilgrim’s reward would be met.

The King’s servants began placing grains of rice upon the chess board – one in the first square, two in the second, four in the third, eight in the fourth and so on.

It didn’t take the King long to realise that he may have bitten off a little more than he could chew. He calculated that by the 30^th square he would be required to put down 1 billion grains of rice, and by the 64^th and final square he would need to reward the pilgrim with roughly 18,000,000,000,000,000,000 grains (that’s eighteen quintillion for those playing at home). That is about 210 billion tons of rice, the same as around 10.5 million sphinxes of Egypt – or enough to cover the whole of modern-day India in a one metre thick layer of rice.

The pilgrim, being the kind and understanding individual that he was, acknowledged that it was a ridiculously large amount of rice and agreed that the king could pay it off annually, and even pay him in other assets like gold or land.

How does compound interest work?

When you save and invest money, all being well, you’ll earn a rate of return on your investment.

The words ‘return’ and ‘interest’ are interchangeable. This is why you’ll sometimes see compounding called ‘compound returns’.

Both mean the same thing, just a tweak in the language.

So, imagine you invest £100.

And in a year, you get a 5% return. This will mean that you end up with £105 by the end of the twelve months.

In the following year, you reinvest that £105 for another 5% return. By the end of the second year, you’ll have £110.25, without you having to add in any extra money.

I’m not suggesting that a fiver will change your life.

But, when you start using larger sums and allowing more time for the money to compound, the growth results are pretty astonishing.

How do you calculate compound interest?

There is a complex-looking formula for compound interest which you should look up if you’re a bit of a maths geek.

But for the most part, you don’t need to calculate things manually using the formula.

The easiest way to calculate compound interest is by using a calculator.

If you’ve never used a compound interest calculator before, you’re in for a treat.

They’re very easy to use and if the results don’t get you pumped about investing and growing your money, I don’t know what will.

Here’s a couple of online calculators you can have a play around with to see for yourself:

Do stocks give compound interest?

Yes, they can, but not every stock or share will.

For some stock investments, you’ll earn a return due to the growth in the value of the shares.

You can still build wealth this way, but because you’re not locking in the returns, it’s not necessarily compounding.

Compounding in the stock market works best with investments like:

This is because, all these investment options can generate a return that is paid out to you, which you can then reinvest.

It’s the reinvesting of returns that leads to true compounding.

Can you get rich from compound interest?

You certainly can. The key ingredients to becoming rich with compound interest include:

Time
Steady and consistent returns
Regular investing
Low fees and costs

It’s worth pointing out – how much time you have and the return you generate may be out of your control.

Don’t fret if your time horizon is shorter, just make the most of the time you do have.

If you are younger and have time on your side, it’s so important to invest early. Because, small amounts over those extra years will pay off in the long run.

Choosing to invest regularly and opting for low fees is actually something you can control, so make sure you do.

Investing even just small amounts will be worth it. I know that there might be a big squeeze on your money right now, but anything you can manage will go a long way.

If you’re struggling to find a cheap brokerage account, eToro is a great option. It’s free to open an account and there are no fees for buying investments.

Just like your returns compound, so do your costs. Cheap is good, free is better.

If you need a hand with getting set up, we created this great guide explaining how to create an account and buy shares with eToro.

Using compound returns to build wealth

To show you just how powerful compound interest can be, here’s a rough example to give you an idea of the magic.

If you begin investing at 20 years old and invest £50 a month until you’re 60, with a 5% return each year, you’d end up with just over £100,000.

Now, if you changed it up and got a return of 9% (which is roughly the yearly return from the S&P 500 index), and you invested slightly more at £250 a month, you’d be left with £1,170,000 by the time you turn 60.

What’s incredible about this is that only £120,000 of that figure is from your monthly investments.

The remaining £1,050,000 is pure interest due to compounding!

However, if you’re not savvy with your accounts, this figure would be much lower if you have high costs or pay lots of tax on that growth.

The best way to (legally) to avoid paying tax on the growth of your investment portfolio is by making sure you make the most of your stocks and shares ISA.

You get a £20,000 allowance each year, which is plenty for most of us.

Keeping your investments in this tax wrapper protects the growth from dividend and capital gains tax. And, you don’t pay any income tax once you start withdrawing or living off your portfolio.