How Money Makes Money

Albert Einstein is one of history's greatest minds. Imagine if he had something to say about investing – would you listen? Of course you would.

Well, as luck would have it, Einstein did share his thoughts:

‘Compound interest is the eighth wonder of the world. He who understands it, earns it… He who doesn’t, pays it.’

In other words, Einstein was saying that money makes money.

Compound Interest

Compound interest refers to the principle that when you save money, as well as earning interest on the savings, the interest itself attracts more interest.

Think of it like a snowball rolling down a hill. As you roll it, it turns and turns and picks up more snow, making a bigger snowball. The larger the snowball gets, the more snow it can pick up, and the faster it grows in size.

An example.

If you start with £1,000 and earn 10%/year, after one year you’ll have £1,100.

In year two, your interest from year one becomes part of your base. So you make 10% again, but this time on a base of £1,100. As a result, your earnings in year two are £110 (10% of £1,100). Your total now is £1,210.

In year three, you make 10% again, this time on a starting amount of £1,210. Your earnings are £121, giving you a total of £1,331.

Over the three years, you earn £331 – a 33.1% return – even though your individual returns were only 10%/year. This is the power of compound interest – your interest earned becomes part of your base, and itself attracts interest.

That’s why – over more time – your returns look like this:

The First £100k

The first £100k is always the hardest. It requires you to save year after year and earn good returns on your investments. But once you’ve reached £100k, the next £100k is easier.

To get that second £100k, you have help, because your first £100k will earn compound interest. So the time to reach the second £100k will be shorter than for the first. And the third £100k will be quicker still.

Income from Job vs Income from Investments

If you save and invest for many years, you may even earn more from investments than from your salary.

At the beginning of your working life, with £10,000 in savings, a 10% return in a year will only give you a £1,000 gain. Not bad, but not life-changing. The money you save from your salary will be more significant.

But once you’ve got £500,000 in savings, a 10% return will yield £50,000 – probably much more than what you save in an entire year.

At the beginning of your life, it’s the amount saved that is most important. But as time passes, the return on your savings becomes crucial.

The Implications

As you can see, money makes money. This fact has three important implications:

Number 1 – the money you save now is not just worth its face value, but all the future gains on that value as well. If you saved and invested £1,000, it could be worth £10,000 or more later in life, as money makes money. So by spending £1,000 now, you are actually forgoing £10,000. Knowing this dramatically changes the trade-off you have between saving and spending.

Number 2 – at the beginning of your financial journey, it’s all about how much you save. But after a while, your returns on the money you have saved become more important, and eventually the returns on your investments become larger than your salary. So it’s important to do both - save well and invest well, starting now.

Number 3 – use compound interest to your advantage. If it was powerful enough for Einstein, it’s good enough for you. If you don’t use it, others will, and you’ll be left behind, having to work harder and longer to compensate.

Don’t make finances harder than they need to be. Money makes money – use it to your advantage.