How compound interest works; what you need to know.

Interest is calculated either on a simple basis or compounded, and which is applies to you makes a big difference to your savings and borrowings.

Simple interest is the application of a percentage rate to the principal sum, whether borrowed or saved, for the time frame in question. Compound interest is interest on the principal sum plus the accruing interest.

Last summer, in the balmy pre-credit crunch days, statistics (Creditaction) indicated that around 45% of the UK population had no idea what interest rates they paid on their debt, or what they received on savings. The ensuing financial belt-tightening in the economy has hopefully focused a lot more minds on the importance of knowing their interest rate, especially if it is compounded. Otherwise they could be among the record 120,000 people expected to go bust this year because of unmanageable borrowing, according to predictions from accountants Grant Thornton.

The Bank of England has already warned that the level of debt-harrassed households is at its highest for almost 15 years.

Financial wonder

A key element in debt management, indeed in every aspect of borrowing and saving, is knowledge of the workings of compound interest. Referred to by Albert Einstein as the greatest mathematical discovery of all time (along with the likes of John Maynard Keynes and Benjamin Franklin he also considered it the eighth wonder of the world) compound interest is a relatively simple concept.

In effect, when saving you earn interest on your interest, when borrowing you pay interest on the interest accrued. The longer you borrow for (without repayment) the quicker the debt mounts up. The earlier you start investing or the longer you save for (without withdrawing any interest) the more significant the final sum.

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Doubling the amount

The value of compound interest for savers really kicks in after 20 years as this example shows: £1,000 invested at a compound rate of 10% and left untouched would yield £2,594 by year 10, £6,727 by year 20 and £10,830 by year 25. Conversely, if you borrowed £1,000 at the same rate, made no repayments during the period, then these are the sums you would owe.

As a rough rule of thumb, dividing the number 72 by the annual interest rate gives the approximate time taken for debts or savings to double when subject to compound interest (this rule becomes less accurate for rates in excess of 20%).

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At 6% compound interest, an amount will double itself within 12 years (precisely 11 years, 327 days). By comparison 16 years and 8 months are needed before an amount doubles at simple interest. Compound interest has a snowball effect; growth in the sum invested or the amount borrowed is slow at first but then begins to accelerate into a substantial benefit or a financial headache. Obviously, the interest rate itself is significant; the difference between investing at, say, 7% or 8% over a long period of time will be considerable.

10 January 2008 © Moneyextra.com

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