Confused by compounding: Why it matters

Einstein called compounding the eighth wonder of the world. He was referring to the dramatic difference it can make to our lives, but it shares more than that with the wonders of the world. It’s also, mysterious, difficult to visualise, and our recent survey showed over 50% of people don’t understand it.

If you’ve always struggled to click with compounding, it can be incredibly off-putting when people bang on about it. However, it’s worth spending a few minutes getting to grips with it, because it can help you make more informed decisions about everything from saving and investing to borrowing.

This article isn’t personal advice. If you’re unsure an investment is right for you, please seek advice. Unlike the security offered by cash, investments and any income they produce can fall as well as rise, so you may get back less than you invest.

At its heart, it’s essentially just growth piled on top of growth, but given that one in ten people have had compounding explained, and still don’t understand it, it’s worth considering an example.

If you were to save £100 and get 5% interest a year – paid annually – you’d make £5 of interest and have £105 at the end of the year. If you were asked what you’d make after two years, you might guess £10 and after three years you might assume £15 – leaving you with £115 overall.

However, that’s not quite how it works. In year two, you’re not getting interest on £100, you’re making it on £105, so you’d get £5.25 in interest, and you’d have £110.25. Then in year three, you’d make 5% of £110.25, which is £5.51, so you’d have £115.76.

On a small sum of money over a short period of time, it doesn’t feel like a massive difference, but it adds up pretty spectacularly over the years. If you were to save or invest in a £20,000 stocks and shares ISA for 20 years, with 5% annual growth, if you excluded the impact of compounding, you might expect to get 5% of £20,000, 20 times, leaving you with £40,000. In fact, because you’re getting growth on your growth, you’d end up with £54,253.

Remember to note these are hypothetical growth figures and what you will actually get will depend on the underlying investments and how they perform, account charges and personal and tax situations. ISA and tax rules can change and any benefits depend on personal circumstances. Past performance isn’t a guide to future returns.

The overall impact depends on a handful of factors. Key is the growth rate, which dictates how much compounding adds up. Typically, you get faster growth over the long term from investments than from cash savings, so you get more compound growth. It also depends on how often growth is added to the pot, so it works faster if it’s added daily rather than annually. And it depends on how long the money is working for you.

Fundamentally, it also hinges on whether it’s working for you or against you. While it’s your friend when you’re saving and investing, boosting the growth significantly, it works against you if you’re borrowing and not repaying enough to keep pace with the interest – because you’ll end up paying interest on the interest, compounding the cost of borrowing.

An understanding of compounding can help you appreciate the longer-term focus of investing and saving, and the costs of borrowing. You don’t have to be Einstein to get to grips with it.