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Finance Friday: Compound interest

Many people don’t understand compound interest and some people don’t even understand percentages. Compound interest isn’t too difficult, it simply means you get interest on the interest in the second year and subsequent years.

Most countries have decimal currency and so that makes understanding percentages easy. If you are in the US, you have 100 cents to a dollar, in Europe 100 cents to a Euro and in The UK 100 pence to the pound. If you’re earning 4% interest on your savings, that is simply 4 pence (or 4 cents) on every pound in your savings account. Where people get confused is when percentages are expressed as fractions or decimals.

From July people in the UK will be able to invest via an ISA up to 15,000 pounds and the returns will be largely tax free. The money can be put into a cash ISA or a stocks and shares ISA. The name might change to New Individual Savings Account and so the ISA might become the NISA. You couldn’t make it up, but officials love their acronyms. Investing on the stock market is complicated and risky, but with a little practice you can make a return better than 10% which is a lot more than savings accounts will offer. You will be charged a annual of a monthly ISA charge so you have to shop around. You can invest in a fund, but if you self select the shares to invest in, there are dealing fees on every transaction and 0.5% stamp duty. Dealing fees seem high for small investors. Reinvesting your money year after year and reinvesting dividends from your shares has the same effect as compound interest. You get a return the second year on the money reinvested in the first year and so on. If you invest 5000 and managed a return of 10% after one year that would grow to 5,500, but invest it again and the extra 500 and the next year it will grow to 6050 and so on.

Over a 8 year period your investment will more than double.

Year 1: 5500

Year 2: 6050

Year 3: 6655

Year 4: 7320.5

Year 5: 8052.55

Year 6: 8857.80

Year 7: 9743.58

Year 8: 10717.94

Obviously, if you add a little to your investments each year, they grow very much faster.

It is difficult to invest when you’re saving to replace household items and saving for even bigger things like a replacing the car and maybe holidays. Investing in a cash ISA might be a better option for short term savings, but if you want money to retire on and you have the time to become familiar with the stock market then a stock and shares self select ISA might be a good option.

Finding a little spare money to invest is hard for many people, so paying off debts is the first things to do. There are some options that will save money. Paying car insurance for the year rather than monthly can save 10% off the premium and paying line rental  on your phone a year in advance can save even more. These things are basic investments that give a good return as you get your finances under control. As your finances become more controlled, more money is left for saving and investing. You don’t have to double the amount of money your have, to double your standard of living. If you have a lot more money left after paying for the essentials, you will feel your standard of living has improved. However, the object of saving and investing for many people is to acquire more financial security, not simply more money.

What do you think? Please share your thoughts in the comments box. You can also follow me on Twitter.

One Response

  1. Pingback: The Review: Setting up a blog | Mike10613's Blog

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