"Compounding interest is the eighth wonder of the world", according to Albert Einstein. We all understand the basic concept of it. However, the magnitude of it is sometimes lost. If your great grandfather invested just $25 for you 100 years ago and you managed to get 10% interest on it per year it would now be worth $344,515.31.
How can $25 turn into a whopping $ $344,515.31 in 100 years?
Compounding. Every year, you get interest on the capital that you originally invested but you also get interest on the interest from the previous year. This table might help to illustrate compound interest in action.
This shows how a $10,000 investment getting 10% interest per year will become over $41,000 in five years.
| Year Begin | Years | Interest | Year end value |
| £10,000.00 | 0-1 | 10% | £11,000.00 |
| £11,000.00 | 1-2 | 10% | £13,310.00 |
| £13,310.00 | 2-3 | 10% | £17,715.61 |
| £17,715.61 | 3-4 | 10% | £25,937.42 |
| £25,937.42 | 4-5 | 10% | £41,772.48 |
| Lump sum | Years left for | Interest | Year end value |
| £10,000.00 | 10 | 5% | £16,288.95 |
| £10,000.00 | 10 | 10% | £25,937.42 |
| £10,000.00 | 20 | 5% | £26,532.98 |
| £10,000.00 | 20 | 10% | £67,275.00 |
| £10,000.00 | 30 | 5% | £43,219.42 |
| £10,000.00 | 30 | 10% | £174,494.02 |
Over the past seven years interest rates have been fairly low, well below 5% in most developed countries. However, prior to the recession interest rates were floating from 5% - 17%!
Click HERE to see the bank of England's historical interest rates. A briefer version is pasted below:
| Date | % | Date | % | |
| Thu, 05 Jul 2007 | 5.75 | Wed, 04 Sep 1991 | 10.375 | |
| Thu, 11 Jan 2007 | 5.25 | Fri, 24 May 1991 | 11.375 | |
| Thu, 03 Aug 2006 | 4.75 | Fri, 22 Mar 1991 | 12.375 | |
| Thu, 05 Aug 2004 | 4.75 | Wed, 13 Feb 1991 | 13.375 | |
| Thu, 06 May 2004 | 4.25 | Fri, 06 Oct 1989 | 14.875 | |
| Thu, 06 Nov 2003 | 3.75 | Mon, 04 Sep 1989 | 13.875 | |
| Thu, 06 Feb 2003 | 3.75 | Thu, 25 May 1989 | 13.75 | |
| Thu, 04 Oct 2001 | 4.5 | Thu, 25 Aug 1988 | 11.875 | |
| Thu, 02 Aug 2001 | 5 | Thu, 21 Jul 1988 | 10.375 | |
| Thu, 10 May 2001 | 5.25 | Thu, 07 Jul 1988 | 9.875 | |
| Thu, 08 Feb 2001 | 5.75 | Fri, 10 Jun 1988 | 8.375 | |
| Thu, 13 Jan 2000 | 5.75 | Tue, 17 May 1988 | 7.375 | |
| Wed, 08 Sep 1999 | 5.25 | Thu, 17 Mar 1988 | 8.375 | |
| Thu, 10 Jun 1999 | 5 | Mon, 01 Feb 1988 | 8.875 | |
| Thu, 04 Feb 1999 | 5.5 | Wed, 04 Nov 1987 | 8.875 | |
| Thu, 10 Dec 1998 | 6.25 | Thu, 06 Aug 1987 | 9.875 | |
| Thu, 08 Oct 1998 | 7.25 | Tue, 28 Apr 1987 | 9.375 | |
| Thu, 06 Nov 1997 | 7.25 | Mon, 09 Mar 1987 | 10.375 | |
| Thu, 07 Aug 1997 | 7 | Wed, 15 Oct 1986 | 10.875 | |
| Fri, 06 Jun 1997 | 6.5 | Fri, 18 Apr 1986 | 10.375 | |
| Tue, 06 May 1997 | 6.25 | Fri, 11 Apr 1986 | 10.875 | |
| Thu, 06 Jun 1996 | 5.6875 | Wed, 15 Jan 1986 | 12.375 | |
| Wed, 07 Dec 1994 | 6.125 | Wed, 20 Mar 1985 | 13.375 | |
| Mon, 12 Sep 1994 | 5.625 | Mon, 28 Jan 1985 | 13.875 |
So it might not seem worth while saving with today's current interest rates but, if they return to previous highs then savers should be able to grow their retirement funds with ease. Additionally, interest isn't just confined to the interest payments paid by banks. If you have shares (stocks) that rise in value and/or pay dividends every year then this rise (called the yield) can be calculated as interest. That is, as long as you reinvest the dividend payments.
Take a Step Back
The rises in wealth can be dramatic. However, there is something that needs to be taken into account before you can calculate how much a pot of wealth has really risen. Inflation will continually eat away at the real value of your savings. Hopefully the amount that your savings are earning will be beating the rate of inflation.
If you're unsure of what inflation and deflation are, click here (links coming soon) for a brief summary.
The number 72?
To workout how long it will take for your investment portfolio to double you:
divide 72 by the interest rate that your getting.
For example: if you're getting 5% interest on your savings of $10,000, it will take 72/5 = 14.4 years to double (turning your $10,000 into $20,000). Change 5% to 8% and it will be 72/8 = 9. It will take 9 years to double
Reverse it
To work out how much interest you need to double your investment in a set period of time you can do the same.
For example: You have $10,000 and you want to know what interest rate you will need for it will become $20,000 in 10 years. The maths would be 72/10 = 7.2. You would need to be getting 7.2% interest on your investment for it to double in 10 years.
