One of the key reasons it’s so important to invest earlier and more frequently is because of something called compound interest.

What is compound interest?

To put it simply, compound interest is when you earn interest on both the capital you have invested and the interest you have already received. It allows money to grow exponentially over time and can help savers and investors to turn small capital sums into large cash piles over many years. Referring to it as one of the greatest “miracles” known to man, Albert Einstein described compound interest as “the most powerful force in the universe”.

But it was perhaps Benjamin Franklin who best captured the meaning and value of compound interest when he defined it as “Money makes money. And the money that money makes, makes money.”

People as successful as American business magnate Warren Buffet have attributed their wealth to “coming from a combination of living in America, some lucky genes and compound interest”. We can’t count on the first two attributes to help us become a billionaire, but all of us can take advantage of the extra wealth that compound interest can offer.

The snowball effect

We all know what happens when you push a small snowball down a hill. It continuously picks up snow and becomes a gigantic snowball when it reaches the bottom of the hill. The snowball effect is an analogy for compounding. It explains how small actions can lead to big gains over time.

Compounding is perhaps easiest to explain in terms of typical cash savings accounts paying interest, but the impact of inflation on cash savings, as we will highlight later in this article, erodes the purchasing power of your money.

For example, if you were to deposit £100,000 in a bank account for 10 years with an annual interest rate of 4.0%, you’d receive:

• £4000.00 interest income in the first year
• £4160.00 interest income in the second year
• £5693.24 interest income in the tenth year

Your total cash pot after 10 years would now be worth £148,024.43.

Playing the long game

You won’t see the benefits of compound interest overnight – it takes time to build and suits a conservative, long-term investing approach.

For example: if a family invests £3,000 a year (approximately £250 per month) for their newborn daughter into a diversified equity portfolio, they will have invested circa £75,000 by the time she is 25. If this portfolio achieves a 5% annual growth rate over this period and all dividends are reinvested, she will also have received just over £75,000 from accrued investment returns. At age 25, she will have £150,340.

Compound interest doesn’t always work in your favour

When you borrow money you’ll be at the mercy of compound interest working against you. Just watching the balance barely move after making a payment on a high interest credit card balance puts this in stark perspective. Albert Einstein captured this issue perfectly in his famous quote “Compound interest is the eighth wonder of the world. He who understands it earns it, he who doesn't, pays it."