Compound Interest
A quick tour, of what is according to Einstein; “The most powerful force in the universe.”
If you are ever hoping to retire with a reasonable amount of savings or pension pot, then it's really useful to understand the basics of how this works, because over time it can make a very big difference to the amount your savings increase. Please don't be scared off by the idea that this is about maths... It's actually about how to get rich slowly :)
Compound interest arises when interest is added to the principal, so that, from that moment on, the interest that has been added also earns interest. This addition of interest to the principal is called compounding. As you can see from the graph below the more frequent your interest is calculated and paid out, the quicker your savings grow. So four identical savings accounts all paying the same interest rate will not produce identical returns. The frequency of interest payment will make a substantial difference over time.
 |
| The effect of earning 20% annual interest on an initial 1,000 investment at various compounding frequencies |
Looked at in another way you can say that Compound interest is the amount that a pound (or Dollar, Euro etc) invested now will be worth in a given number of periods at a given compounded interest rate per period.
I've created some examples in Microsoft Excel to show how this works, which compare the returns available from ZOPA against the best savings accounts available, which I'll share in a future blog post.
Excel does not include a function for determining compound interest, but you can use the following formula:
=PV*(1+R)^N
where PV is present value, R is the interest rate, and N is the number of investment periods. 
No comments:
Post a Comment