The Compounding Effect


    Often when reading about interest rates, many adverts will tell you to act quickly and or you’ll suffer the ‘cost of delay’. But if you choose where to put your money now or in 6 months’ time, your starting balance is the same, so what is the rush for consumers? Is it just a ploy for financial service providers trying to increase their customer numbers?

    The focus of this post is to understand why it is in your interest to act sooner rather than later. There is, of course, a benefit to the financial service provider; the sooner they get your money, the better it is for them. However, the cost of delay is certainly something worth considering from your own point of view as well, especially when thinking about making your money work as hard as possible for you. Essentially, the cost of delay comes about from the loss of compounded interest. None other than Albert Einstein called compound interest the “eighth wonder of the world”, stating “He who understands it earns it, he who doesn’t pays it.”

    Compounding is, essentially, interest earned (or charged) on interest, which creates a snowball effect. The power and impact of compounding is easiest seen over longer periods of time; whilst you won’t feel significant effects immediately, the longer you give your money to grow, the more you’ll see the beneficial impact of compounding. The cost of delay refers to the fact that the benefits of compounding can’t start to be felt until interest starts to be earned.

    The compounding effect is boosted by higher interest rates. Big banks make much of their money by relying on customer lethargy, from those who delay choosing better options for their savings; you can read more about this here. By leaving sums of money in low interest accounts to think about again 6 months down the line, you are missing out 6 months’ worth of higher interest that could have been compounding the whole time; whilst the benefit may not be significant over 6 months, the benefit will grow the longer those savings are held. In a low interest environment, compound interest can also help to combat the effects of inflation. By taking ownership of your finances now and making active choices, you’ll personally start to feel the positive effects of the snowball effect that others might be missing out on. And Albert Einstein would be proud of you.

    We've explored Albert Einstein's think of the Rule of 72 and apply it to the effects of compounding interest to figure out how long it would take to double your money using a nifty trick.

    Sophie Redgell
    Investment Marketing Team

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