Albert Einstein is here to present lesson five in our BUX homeschooling series. Don’t worry, this isn’t a lesson about quantum mechanics or the theory of relativity. It’s a phenomenon that fascinated even Einstein: earning interest on your interest.
Put your money to work
Einstein even called it the 8th wonder of the world. Interest on interest, also known as return-on-return or compound interest, is a way to make your money work for you. And we all want that, right?
This effect is best explained with a very simple example.
Suppose you invest £1,000 every year and you get a 5% return annually. After the first year you’ll have £1,050. So far, so simple.
In the second year you put in another £1,000 and at the end of that year you will receive another 5% return.
Let’s do some quick maths. That’s 5% on £2,050 = £102.50. And that puts you at a total of £2,152.50 after the two years.
In other words, you’re making £100 interest on the £2000 you deposited. But you’re also making £2.50 on the interest from your first year. It’s interest on interest, without doing anything else at all.
Now, £2.50 doesn’t sound like much. But don’t forget that this effect continues to grow year after year. So the third year looks like this:
£2,152.50 + new £1,000 investment = £3,152.50 + 5% interest = £157.62 for a total of € 3,310.12
At the end of the third year, this £157.62 consists of £150 interest on your own invested money and £7.62 of compound interest. So this effect has tripled after a year!
Keep doing this for a few more years and you’ll see what wonderful interest-on-interest can lead to.
Patience will be rewarded
This is a simple example, of course. It doesn’t take into account fluctuating returns or different deposit amounts. But this phenomenon gets really exciting if you keep doing it for a long time, say 20 years or longer, without withdrawing money in the meantime.