COMPOUND INTEREST: It is a simple enough concept, and it can be genuinely life-changing.

What's the eighth wonder of the world?

According to Albert Einstein, it is, compound interest!

The man with the big brain dubbed it ''the most powerful force in the universe'', and warned that ''he who understands it, earns it ... he who doesn't ... pays it.''.

While the origins of these quotes are a bit fishy, never a truer word was spoken (or made up).

Research by the Commission for Financial Literacy and Retirement Income suggests roughly a third of us are in that second category. We just don't get it.

But you don't need to be an astrophysicist with an IQ of 160 to figure it out. It is a simple enough concept, and it can be genuinely life-changing.

What is Compounding?

When you give a bank or someone else your money, they pay you for having the use of it. This is called "interest".

If you leave that interest sitting in the account, it starts attracting interest all of its own. This interest-on-top-of-interest effect is called compounding.

The exact same principle applies to other forms of returns, like dividends from shares.

Over time, there's a major snowball effect. Eventually, the original amount you put in has been dwarfed by loads of interest.

Warning: Double-edged Sword

If you owe someone money, and don't keep on top of repayments, the interest will compound in exactly the same way.

However, we are going to focus on how to turn it to your advantage.

In For the Long Haul

Let's say you have got £10,000 invested, and you are earning a 7 per cent return. By the end of the year, you have earned a little more than £700.

It might seem like it will take an eternity to get rich on £700 a year. But compounding returns really comes into its own over longer time periods.

Imagine that you put away that £10,000 away at the start of your career, say, age 20, and then simply forgot about it.

Forty-five years later, that £10,000 would have become £230,000, without you so much as lifting a finger.

 February 2020