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What is compound interest

When it comes to explaining compound interest we like to use the analogy of a snowball fight. Imagine you are at the top of a mountain and you have just made a snowball. At the start it is a small snowball and if you threw it at someone it wouldn’t have a great deal of impact. Instead you decide to roll the snowball down the mountain so that as it turns and turns it actually picks up more snow, making a bigger snowball.  The bigger the snowball gets, the more snow it can pick up and the faster it grows in size. You decide to keep rolling the snowball until you get the size want to win your snowball fight!

With an investment it might start off small but as it earns interest, the investment and the added interest, earns more interest. So, the younger you start saving, the longer your money has to grow. The concept of interest on interest is also known as compound interest and this is what can cause wealth to grow.

Let’s look at a practical example. From the age of 20 to 30, someone saves £100 a month, £1,200 a year. This is a total amount of (£12,000) with a standard annual growth of 5%. By year 29 this be worth £80,811. This nest egg alone would be worth £117,149 by the time that person reached 70. In comparison, someone starting to save from the age of 40 would have to contribute £200 a month, £2,400 a year, for 15 years, until the age of 55 to get a similar value of £118,700. Take a look at our compound interest calculator to plot a few figures of your own.

A lot of younger people think they aren’t rich enough to invest money but receiving professional financial advice early on means you’ll be able to avoid losing valuable allowances and take advantage of tax breaks. Actually financial advice is not as expensive as what people think so getting into good money habits now can bring huge benefits throughout your life.

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