Compound interest is the magic ingredient for savers looking to grow long-term investments. Once described by Albert Einstein as “the eighth wonder of the world”, compound interest is basically interest that you earn on the interest that’s already built up on your savings. Because it works by accumulating over time, compound interest can turn a small savings pot into a significant amount when left untouched.
How to calculate compound interest
Instead of paying out the early interest on your savings, compound interest works by reinvesting it. Then the next time interest is calculated it’s earned on the principal sum, plus the interest you’ve previously accumulated, and so on.
- Example 1
If you pay £1,000 into a pension fund with interest growth of 5% per year you’ll earn £50 interest in year 1. Leave the money as it is and in year 2 you’ll earn £52.50 interest and £55.13 interest in year 3.
- Example 2
Now pay £1,000 into the same pension fund, with interest growth of 5%, every year for five years. In year 1 you’ll earn £50, in year 2 you’ll earn £102, in year 3 you’ll earn £158 and in year 4 you’ll earn £215. By the end of year 5 compound interest will have increased your pension fund by £801.
Pensions and compound interest
Compound interest can be highly beneficial for pension savers as it builds and grows over time. Interest gets paid into your pension plan and is then reinvested again, meaning the longer you leave money in your pension, the more compound interest it’ll generate and the larger your pot could become.
Compound returns are greater the earlier you start investing in your pension and the longer you leave it, so wherever possible it’s a good idea to start saving early and hold off from drawing your pension for as long as possible.
Even if you can’t afford to save much into your pension, it’s worth investing what little you can. If you’re enrolled in a workplace pension scheme you’ll have to pay in a minimum of 3% while your employer has to contribute at least 2% of your qualifying earnings. Tax relief of at least 25% from the government also applies to your share of these contributions, meaning that when you factor in compound interest, it’s not hard to see how small contributions can significantly add up over time.
Pension growth calculator
If you’re unsure about how much money you should be saving for retirement our pension growth calculator can help you do the maths. You can find out if your savings are on track and formulate a strategy by following these four simple steps:
Set yourself a retirement goal and consider how much you’d like to receive for each year of your retirement
Enter your current age and the age you’re planning to retire
Tell us about the value of any pensions and savings you already have
Add in how much you’d like to pay into your pension each month/ year and adjust the amount until you reach your retirement goal
It’s estimated that saving around 15% of your salary is a good place to start when contributing to your pension. But this will depend on how old you are and when you plan to retire, as the closer you are to retirement when you start saving, the more you’ll need to save. If you’re planning to retire early, or at 55 when you can access your personal pension, you’ll need to save significantly more in a smaller time frame.
No matter how much you’re able to save into your pension each month, provided you leave your pot untouched for as long as possible, compound interest will gradually build over time and can help you reach your retirement goal faster.
As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.