How does compound interest grows your savings?

When thinking about saving, your first thought might be how much you earn and whether you can afford to save. Knowing your numbers though, makes it simpler to put aside a small amount every month to grow your wealth.

So let’s start with that first thought. Think you don’t earn enough?

If you earn $25,000 a year, for 40 years, you would earn $1 million.

If you earn $35,000 a year for 40 years, you would earn $1.4 million.

If you earn $50,000 a year for 40 years, you would earn $2 million.

But this is too simplistic! We haven’t considered tax paid on your earnings, plus financial commitments you may have and the cost of living. So it’s not a true reflection of your earnings.

So let’s look at this differently. How much can you afford to save? Let’s say you save $100 a month for 40 years:

At 3% interest, you would have close to £93,000.

At 5% interest, you would have close to $153,000.

Your savings have grown faster as you’ve invested the money you’ve earned in interest each year. This is along with the money you began with. This is known as compounding and it’s incredibly important for growing your wealth.

What is compound interest?

Compound interest in simplest terms, is earning interest on your interest. It applies to both your principal investment and to the accumulated interest from previous periods. Compounding helps your money grow faster than if the interest were calculated on the principal alone.

As an example, you invest $10,000 for 3 years that earns 3% interest that is compounded annually. This means the interest earned is added to your investment at the end of each year. This is what your investment looks like at the end of 3 years:

Year	Value at start of year	Interest earned	Value at end of year
1	$10,000	$300	$10,300
2	$10,300	$309	$10,609
3	$10,609	£318.27	$10,927.27

In 3 years, your investment has earned $927.27. If you were to continue to add to your investment or hold it for longer, the compound interest can really add up.

The longer the money is invested, the greater the compound interest growth will be. So for savings and investments, your money multiplies at a fast rate. But the same applies if you have debt. Compounding the interest can make it difficult to pay off.

Start saving as early as possible

Ultimately, compound interest points to saving as early as possible. Most people don’t think about saving for retirement as they prioritize other expenses. Most will think to save later in life. But as seen above, even saving small amounts can pay handsomely thanks to compound interest. As an example:

You start saving $100 a month at 20 years old. You earn an average of 3% annually; with the interest compounded monthly across 40 years. You will earn $114,037.30 by the time you are 65 years old. Your investment or regular saving was just $54,000. You earned $60,037.30 in interest.

But we can flip it around too. Let’s say you don’t start saving until you’re 50 years old. You choose to invest $5,000 initially, and $500 monthly for 15 years. Considering the same average 3% interest annually; with interest compounded monthly. You will earn $121,323.50 by the time you are 65 years old. Your investment or regular saving was $95,000. You earned $26,323.50 in interest.

Whilst the above example shows earnings slightly higher when saving later in life, the ideal scenario is a combination of both. So start saving early and increase the savings amount per year where possible later on.

This online calculator can help you understand how your savings can grow over time.