The Magic Of Compound Interest

Posted by E.A. Mann on April 23
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For all the magic and wonder of compound interest, its most incredible trick, at least to me, is how easily it can potentially make a millionaire out of an early saver. 

Imagine you’re 20 years old and fresh on the job. To become a millionaire, how much do you think you’ll need to save? Well, if you put away £375 per month in an investment – under £100 per week - you’re well on your way. At 65, you’ll have just over £1M in the bank assuming a steady 6% yearly return after all costs and fees. With an 8% return - which is also possible (nothing is guaranteed) – it would only take you £200 per month to get you to millionaire status. Incredible stuff. 

But as compound interest giveth, it also taketh away. If you wait until you’re 30 to start investing, it’ll take £675 per month to become a millionaire by age 65. This is eye-popping to me; chop off 10 years and you need to double your savings. Starting at 40? I’m almost frightened to tell you that it’ll take £1,450 per month to hit millionaire status. Starting at 50? Let’s just not do the maths and pretend we did. 

So the maths is clear: compound interest favours the young, the early savers, to a huge degree. But young U.K citizens have an additional advantage, which acts like rocket fuel to their savings, making it easier than almost anywhere else to save a million pounds: the Lifetime ISA (LISA). 

Opening up a LISA is dead simple and, if funded regularly, has the potential to boost your savings with no inheritance, fancy job, or luck needed. 

Here’s how it works. You’re allowed to open a LISA at age 18, but for our example let’s start at age 20. Each year until you’re 50 years old, you can contribute a maximum of £4,000 into this account, which is roughly £333 per month. If you do, the U.K. quite generously puts a free £1,000 in there. Grand total: £5,000 per year.  

Now, the LISA is just an investment “bucket”, a place to put your money. Once it’s in there, you can just let it sit idle or you can invest in index funds, shares, etc. Let’s imagine we place it in a simple mix of shares and bonds that return the 6% each year, averaged over time after fees and costs. 

So from ages 20 through 50, you save your £333 per month. For most 20-year-olds, that’s quite a bit of money, but if you progress in your job it will become a smaller and smaller percentage of your pay. Then at age 50, you stop, but you don’t pull the money out. You let it sit and keep growing. At age 65, how much money do we have? 

You’re probably not surprised to find that we have just over £1M sitting in our LISA. And since it’s a special government account the money, which has been growing for decades, has not been taxed. 

Here’s the part that excites me the most - and should excite you. Of that million pounds in the 65-year-old’s LISA, how much did they actually put in? Only £124,000, a mere fraction of the total. The rest came from compounding interest and the generous government match. That is the power of investing young within a LISA. 

So if you’re a 20-year-old, or you know one, here are the three things you need to take away from this: £333 per month + LISA = investment potential. Write it on a sticky note and put it somewhere it can’t be missed: on the fridge, their phone, on their forehead. They’ll thank you later. 

Photo: Igor Son

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Written by E.A. Mann

E.A. Mann is a systems engineer and freelancer who specialises in finance writing. He is passionate about breaking down complex investing concepts so that everyone can understand them, not just the experts.

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