It’s been alleged that Albert Einstein once exclaimed that compound interest was “the eighth wonder of the world” and also “the most powerful force in the world”. Whether or not he actually said these things at all matters not, but what does matter is the reasoning behind these two statements.
Compound interest is essentially, interest upon interest, which is why it is important and beneficial for investors. But it can be bad news for anyone who has borrowed money and has interest on loans they need to pay back.
If you have a debt that you are being charged interest on all the time, day-after-day, year-after-year, it has the potential to increase the debt significantly. An outstanding debt of £10,000 that costs 10% per year on interest, but the interest charge is being added daily, will more than double in seven years.
This is because with compound interest, you are being charged interest, on the interest as well as the amount you originally borrowed. So, the amount can quickly add up and even send you into debt if you let it accumulate into more than you can realistically pay back.
With inflation and interest rates sitting at the highest they have done for a long while, it is key to calculate how much interest you are going to be paying on any money you are borrowing and considering whether it is affordable for you to pay back.
How do types of interest differ?
The maths for compound interest is based on the amount that is outstanding, plus the interest that has been added at a specific point in time. For example, if £10,000 is borrowed with an annual interest rate of 10% and nothing is paid off the loan at the end of the first year, the amount outstanding would then be £10,000 plus 10% (£1,000), so the amount outstanding has now risen to £11,000.
~Novel Serialisation: Heavens Fire~
By the end of year two, the calculation would then be £11,000 plus 10% (£1,100) and the amount outstanding has now risen to £12,100. By year three, it will be £12,100 plus 10% (£1,210) and the amount needed to pay off the outstanding loan has risen to £13,310.
With compound interest when nothing is being paid off, the longer the borrowed money is outstanding the larger the amount to pay off will be, and while compound interest works out really well for long term investors, it can be financially devastating for long-term borrowers.
This is where simple interest, as the name suggests, is much more straight-forward. For this, the interest a borrower is charged is only on the original amount you borrowed. So, for a £10,000 loan charged at 10% interest the borrower will only pay back £11,000. It doesn’t matter if it’s paid back to the lender over one year or five years, the total amount paid back by the borrower will only be £11,000 – simple!
How to use simple calculations to understand your interest level
It’s possible to work out the future value of a loan or investment using a basic calculator. Just type in the annual interest rate being charged as a decimal number i.e. 1.10 for 10% and multiply it by the amount being borrowed. Then just keep hitting the equals sign to see how much the outstanding loan balance increases each year if you don’t pay anything off. You can quickly see the figures going up in front of you.
This calculation works in the same way to estimate what the future value of an investment could be. For both individual and business investors, using this formula to work out the future value of your money by ‘compounding up’ the anticipated returns over a number of years is really helpful as it allows you to see if the money you are considering investing will provide you with a reasonable return over the longer term. For this, compound interest can lead to exponential growth.
For borrowers, using the compound interest formula will help you to work out how much your outstanding loan might be in years to come if you never get around to paying off any of the interest payable. If interest is constantly being added on to the outstanding amount and previous interest added, even a small loan could become a large one in a relatively short space of time.
The main disadvantage for most people who use the compounding formula to work out the future value of their savings or an outstanding loan is that they don’t often allow for inflation, which is very high at present. In turn, this means that savings need to enjoy much higher returns just to keep up with inflation and outstanding loans, which at present, are being eroded by it. This is because of the basic principle that when inflation is running high, any amount of money you can think of just won’t buy you as much ‘stuff’ today as it did last year, or the year before, or the year before that.
We would all love to keep paying the same amount of money for something we buy every year, but unfortunately, with interest rates continually rising at the moment, that can’t be guaranteed. The important thing is to make sure you have a good idea, whether it is a loan or investment, what your end result might be, and how much you will be expecting to pay back, or earn, before you borrow, or invest, any money.
By Ray Black, chartered financial planner and managing director of Money Minder
About Ray
Ray Black co-founded Money Minder with his wife Karron Black in 1999, offering independent financial advice on investments and pensions, and giving individuals peace of mind and reassurance that their life savings are entrusted in Money Minder’s care and guidance.
Since its launch, Money Minder has been the provider of investment and retirement planning workshops to the general public and since 2004 for NHS staff in Lincolnshire. Money Minder has also been included as a recommended provider on www.moneysavingexpert.com.
With expertise in both personal and corporate financial planning, Ray is one of the few advisers in the UK to hold a Master’s in Business and Financial Planning. He is also a fellow of The Personal Finance Society and available for comment on stories regarding pensions and private investments.
Ray is not shy of offering open and honest advice and has become an expert voice in local and national media and trade press. He is passionate about financial education and empowerment and has been helping individuals and business owners to make informed decisions that enhance their wealth and lifestyle for many decades. More than anything, Ray says he “wants to change the world” through ongoing financial education, exceptional customer service and proactive advice.
