Best Savings Rates - Compound Interest Explained

OK - we've looked at simple interest, which I think you will agree hardly sets the pulses racing, even when combined with the best savings rates you can find. If you really want to be wealthy, or even just make your money work harder for you, then you have to combine two things. First, make compounding work for you, and secondly ( and this is the hard part for most people) you have to be disciplined in your saving. Just as an aside, one of the questions I am often asked as a trader and investor is " what is the difference between saving and investing?". The answer is with saving you generally get back all your capital plus interest, with investing you often don't, although I have come across many people with so called 'savings plans' which are losing money ( I had one myself!) - so it's a very fine line, and often blurred at the edges. As we shall see, there are high risk savings and low risk savings. Risk and reward, as in trading, go hand in hand even in the supposedly low risk market of 'savings'.

Best Savings Rates - The Power Of Compound Interest

Compound interest is actually very easy to understand. Remember in the previous example we removed our annual interest each year, so earned the same amount of interest for each 12 month period. Compounding interest is like the wind under the wings of a jet. The plane starts to take off slowly down the runway, but as it picks up speed so the wind lifts the wings and it takes off, rising higher and higher in a steep upwards curve. In a similar way, compound interest will lift your savings, faster and faster the longer your leave them in place.

So to go back to our savings, with compound interest, we simply leave the interest we've earned and add it to our capital each year, so our initial capital or principal( P) is growing every year. Because our principal is growing, so the amount of interest we earn each year grows as well. Let's take our simple interest example from the previous page and see what happens we when use compound interest using 5% interest rates:

So having left your money to compound by adding the interest back into the capital each year, you have earned the glorious additional sum of £128.89 - hardly life changing is it? - or is it? In the above example we have managed to increase our return by 128.89/500 or almost 26% - a substantial amount however you measure success. Now let me give you two further examples which will really make the point, I hope, that saving is not just about finding the best savings rates, but having the discipline to leave your money to work for you.

I am going to assume you are 20 years old and have come into a windfall of £10,000 from a late and much beloved great aunt who has passed away recently. Option one would be to buy a car, option 2 a luxury holiday, and option 3 to save it ( how boring!!) - if you had the discipline to save it in a simple savings account paying 6% compound, and left it there until you were 60, here's how much it would be worth:

A staggering return of 1028% on your original savings, just from the power of compound interest. Finally let me give you an example in US dollars which makes the point graphically.

If you have a child who has just been born, then I would suggest the graph alongside provides a powerful argument for saving 100 US dollars and leaving it there for them to enjoy their retirement or to pay for healthcare. By the age of 70, this tiny amount has increased in percentage terms alone by 10,000 % - a staggering amount from such a small sum. Such is the power of compound interest- ( in this case the interest rate was 7%).

Now let's take a look at AER, or annual equivalent rate - this is the rate that is the official savings rate - so whatever the best savings rates may be, you will need to make sure you are comparing like with like, and to do this you need to understand all about AER.

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