25th February 2020
When looking for a place to invest your savings, you are likely to compare the interest rates offered by the different banks and investment platforms. But it’s not just the interest rate you have to pay attention to... have you considered the effect of diversification, repayment schedules and compound interest? When the interest is calculated and paid can have a significant impact on your earnings in the long-term.
Compound interest is the money you earn on the interest you have already been paid. For example, when you invest £20,000 with Barclay’s Cash ISA, you will earn 1.05% interest after one year. Meaning if you made that investment last December, you would have £20,210 in your account today. Next year you will not just be paid 1.05% of the original £20,000, but on the £210 you earnt last year.
What happens if you are paid interest monthly, as opposed to annually? You are paid interest on what you have earnt every month before. This means you would now have £20,211.01 today, instead of £20,210.00. In five years time, you would have earnt an extra £5.29, just because the bank paid you at a different frequency.
Admittedly, £5.29 barely gets you a pint these days, but this effect becomes important when your investments have a higher interest rate. For example, the target earnings for Crowd2Fund’s investor community is 8.7% APR with their Innovative Finance ISA (IF-ISA). Repeating the example but investing £20,000 in their IF-ISA, you would earn £1,740 interest in the first year and £1,891.38 the following year with annual compound interest. However, as the interest is paid monthly, you could earn another £83.71 in the first year, if you reinvest those earnings straightaway.
The powerful force of compound interest comes into its own for those looking to make long-term investments for their future. If you’re saving for 20 years down the line by investing £20,000 in an IF-ISA, where you are not taxed on the earnings, you could be looking at a balance of £113,233.84, instead of £106,076.91. That is £7,156.93 more paid to you, purely for reinvesting monthly, instead of annually.
Moreover, the latest fund statistics at Crowd2Fund showed the average APR achieved by their investors was 10.33%. In the same example as above, if you invest £20,000 for 20 years and are quick to reinvest your repayments, you would have £156,474.11. Which is £13,616.84 more than if you waited until the end of the year to reinvest.
Choosing where you reinvest to improve diversification and mitigate risk
Another important factor in curating a profitable investment portfolio is using diversification to mitigate risk. As with all investments, there is a chance a company may fail to make their repayments or grow, therefore if you invest smaller amounts in a large range of different opportunities you can offset losses. This is similar to how you might invest in an index fund, as you would expect some companies to fall value and spread the risk accordingly. When you receive repayments, reinvesting in different business in different industries to the ones you are already exposed, can help spread your risk.
How to earn monthly compound interest
Practically speaking, if you prefer to know exactly where your money is invested then you will need to actively reinvest your interest earnings each month as repayments are issued. To maintain a diverse portfolio, using the Exchange can offer more choice for your reinvestments. If you are unable to pay such close attention you may wish to use an automated feature such as Smart-Invest.
To learn more about increasing your compound interest and getting the best rates of return, check out our Investor Top Tips page.
Past performance and forecasts are not reliable indicators of future results. Your capital invested is not covered for compensation in the event of a loss by the FSCS. Tax treatment will depend on the individual circumstances and may be subject to change. Please see our Risk section before making an investment decision.