The secret to getting rich

We explain the secret to getting rich using credit cards, mortgages and savings accounts!

It's claimed that Nobel Prize-winning physicist Albert Einstein declared compound interest to be "the most powerful force in the universe" and "the eighth wonder of the world".

Haven't a clue what he meant? Believe it or not, understanding how compound interest works is the secret to getting rich.

What is compound interest?

To answer, I'll first explain simple interest.

With simple interest, the interest you pay on a debt changes only when the interest rate changes. Thus, if I lend you £1,000 at a fixed rate of 5% a year simple, then you pay me a flat £50 a year in interest until you decide to repay the debt in full.

However, with compound interest, this yearly interest is added to your debt, making it larger and, therefore, increasing your interest bill in later years. Here's how the interest bill on a £1,000 debt at a fixed rate of 5% a year compounds over time: 

As you can see, compounding happens when interest is added to your debt, making both your balance and subsequent interest bills larger. In effect, you're paying interest, plus interest on interest, plus interest on interest on interest, and so on.

Thus, the yearly interest bill shown above starts off at £50 but reaches almost £78 by year 10. Also, the original debt of £1,000 swells to almost £1,629 after ten years of interest being added to it.

Of course, the above example only shows interest rolling up on a debt. It doesn't show what changes when monthly repayments are made. This is where the maths gets a lot trickier!

Compound interest on repayment mortgages

Most home-buyer mortgages are repayment mortgages - but before I explain how those work, let’s look at the alternative: interest-only mortgages.

With a typical 25-year interest-only mortgage, your monthly repayments exactly match the interest owed, leaving your debt untouched. Hence, you need an investment plan to pay off your loan after 25 years. Thus, your debt is level throughout these 25 years and your repayments vary only in line with the interest rate charged.

With a repayment mortgage, you repay your loan as you go along. Thus, your monthly repayments are made up of interest plus a repayment of the outstanding capital.

However, your debt doesn't reduce in a straight line down to zero, because interest charges are highest in the early years, as you haven’t paid off much of your debt. As your debt reduces, you have less interest to pay each month - but, despite this, your monthly payments stay the same. Thus, a greater proportion of your payments each month can go towards repaying the capital of your debt and not the interest on that debt.

This means you’ll end up paying off your debt more quickly towards the end of your mortgage term than you were in the early years.

It’s like a steam train that is gradually accelerating. And the more you put stoke the engine and fight back against the malign compound interest of your mortgage in the early years, the better off you’ll be. You can do this by making monthly or yearly overpayments, and by throwing the occasional lump sum at your loan.

Even relatively small overpayments, say, £25 a month, can save you thousands of pounds and slice years from your loan's life. Try our mortgage overpayment calculator to see how fast you could kill your home loan. With overpayments, compound interest starts working for you, instead of against you!

Compound interest on credit cards

The problem with credit cards that the interest rates they charge are, quite frankly, a huge rip-off. Although the Bank of England's base rate is a tiny 0.5% a year, a typical credit card charges a yearly interest rate of over 19% APR (Annual Percentage Rate).

My next table shows you how difficult it is -- thanks to compound interest -- to pay off a credit card with a minimum monthly repayment of 2.5% of the balance. This is based on a balance of £2,000 and an APR of 19%: 

* Monthly interest of 1.46% compounds to 19% APR over the course of a year.

As you can see, a card debt of £2,000 reduces to £1,756.40 after one year, which is a fall of £243.60. However, your repayments have totalled £573.98, with the difference (£330.38) made up of interest.

In other words, and just like a mortgage, your credit card repayments consist mostly of interest in the early years. This is why credit cards are such a horrifically expensive way to borrow and why even a small card debt can take decades to repay.

In summary, the combination of sky-high interest rates and compound interest make credit cards a terrible way to borrow money, especially over the long term. Therefore, borrow only what you can afford to repay and strive to pay off any card debts as quickly as you can!

If you already have existing debt on a card charging a high level of interest, you could use a low-interest credit card or loan to pay it off cheaply and quickly. Here’s a table of best buys: 

Compound interest on savings

While compound interest is the enemy of borrowers, it is a great friend to savers.

Here's how a savings pot of £2,000 grows over time, thanks to tax-free interest compounding at 4% a year: 

As you can see, your 4% interest is only £40 in year one, but rises every year to reach almost £57 in year 10. As a result of interest compounding in this savings account, the balance exceeds £1,480 after 10 years, which is 48% more than the starting balance of £1,000.

This may not look very impressive, but interest rates are very low right now and should rise in future.

In summary, it is far, far better to earn compound interest than to pay it, so please try to get rid of your debts and become a saver as soon as you can!

(Please note that my credit card calculations assume that interest is added on and your repayment taken off at the same time of the month, whereas real credit cards collect repayments weeks after interest is charged. However, this is good enough for this worked example.) 

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