Blog | RateSetter

How Einstein’s advice can double your money every twelve years

By Luke O'Mahony

Compound interest, according to Albert Einstein, is “the most powerful force in the universe”. The Motley Fool calls it a “miracle”. It has the potential to significantly increase the size of your investments without you having to lift a finger.

Simple vs. compound interest

But what is compound interest? Although it might sound complicated, it’s actually very simple.

There are two forms of interest you can earn on your investments. Happily, the simplest type of interest is actually called simple interest. Imagine you have £1,000 earning 6% in RateSetter’s 5 year product. If you were earning simple interest, you’d earn £60 each year, meaning that you’d have £1,060 at the end of the first year, £1,120 at the end of the second year and so on.

However, if you invest with RateSetter and choose to reinvest your repayments, interest is compounded. This means that not only do you earn interest on your capital, but you also earn interest on your interest too.

So on the £1,000 in RateSetter’s 5 year product at 6% with repayments set to reinvest, you’d still earn £60 in the first year. But in the second year you’d earn 6% on the updated balance of £1,060 giving a gain of £63.60. While £3.60 sounds like a trivial difference, over the years, it snowballs to have a much more significant effect – as the table and chart below demonstrate:

Year

Simple interest

Compound interest

0

£ 1,000.00

£ 1,000.00

1

£1,060.00

£1,060.00

2

£1,120.00

£1,123.60

3

£1,180.00

£1,191.02

4

£1,240.00

£1,262.48

5

£1,300.00

£1,338.23

6

£1,360.00

£1,418.52

7

£1,420.00

£1,503.63

8

£1,480.00

£1,593.85

9

£1,540.00

£1,689.48

10

£1,600.00

£1,790.85

11

£1,660.00

£1,898.30

12

£1,720.00

£2,012.20

...

...

...

36

£3,160.00

£8,147.25

Over the first few years, nothing particularly exciting happens. However, when you get to year 12, you notice that the investment with compound interest has doubled in value and is worth almost £300 more than the one with simple interest. In fact, the compound investment will continue to double every 12 years, meaning that by year 24 you’ll have £4,048 (compared with £2,440) and by year 36 you’ll have £8,147 (compared with £3,160). It takes 17 years for the simple interest investment to double in value.

 

Compound interest for retirement

That’s a staggering difference – over a period of 36 years earning 6%, you could increase your investment eightfold. If you’re investing for retirement planning purposes, that’s a pretty reasonable timeframe, especially given that working lives are likely to be closer to 40-50 years in future.

But here’s the key: you have to start early. If you started 12 years later than the above example, but tried to make up for it by putting in £2,000, you’d still only end up with £8,097 at the end of the term – less than the £8,147 you’d finish with if you invested in £1,000 for the full 36 years!

When investing with RateSetter and choosing to reinvest your repayments, you’ll benefit from the effects of compound interest. And, as the sums above demonstrate, that’s a very handy benefit.

If you want to work out how much you could earn through compound interest, the Motley Fool has a good calculator which does just that.