Spoiler alert: Because money is worth more in the future.
Imagine this scenario. You’re standing in the coffee shop before work. Without realising it, the trip has become part of your daily ritual, and as you approach the counter the Barista takes out their marker pen and starts writing your name on the cup. You get to the till, and they’re already ringing up your soya-latte-frappe-mango-cino, ready for you to hand over your loyalty card. At that very moment, something pops into your head:
“I wonder if I would be better off investing the money that I’m about to spend on this expensive coffee in a pension fund?”
Ok, that scenario isn’t very likely (because who has mango in their coffee?), but what if you did stop to think about the possibility that your money could be worth more in the future? That if you stopped spending £60 a month on coffee and invested that money instead, it could, in fact, be worth much, much more?
The power of compound interest
Let’s look at an example. Frivolous Phil and Frugal Fred are 20, and both have £1,200 in their bank account. Phil goes out and spends it all on a new TV, a Playstation 4 and some fancy-pants new clothes. Fred decides he doesn’t need any of that – his old TV is doing just fine, thanks – but he has heard that investing early in a pension can pay huge dividends in the long run. So, Fred puts it all into a pension fund.
Each month, Phil and Fred earn the same amount of money, and each of them has £100 left over at the end. Phil blows it. He’s only 20, so doesn’t think about a pension – it’s a topic his Dad tries to bore him with, and it’s too far off in the distance. Fred, however, decides to save it.
Fast forward 40 years, and what do they have in their pension pots? Well, Frivolous Phil has nothing. But he does have some pretty cool gadgets.
And Frugal Fred? Well, that’s easy! Fred has 40 (years) x £1,200 (£100 x 12 months) right? A grand total of £48,000. Well done, Fred!
Except that he doesn’t have that much.
He has much, much more, due to the power of compounding.
Let’s say that Fred invested in a balanced pension fund, which was projected to grow at five per cent over its lifetime. In year one, Fred has £1,200. But, in year two, he doesn’t just have twice that amount, he has more, as he earned five per cent interest on the initial £1,200 as well as adding in the next £1,200. He actually has £2,460. Not much more, you might say, but fast forward to the age of 60, when Fred has decided to retire, and he doesn’t just have £48,000. Thanks to compounding, he has around a whopping £160,000!
And it gets even better
It already sounds too good to be true, doesn’t it? Just £100 a month turned into £160,000. Well, we may just be about to blow your mind even more, because our calculation still isn’t right. Why’s that? Well, because Fred invested his money into a pension, which means that as a basic-rate taxpayer, for every £100 that he put in, the government added another £20. So, Fred was actually investing £1,440 each year, which puts his total pot at £191,000!
Which could buy Fred a whole lot of mango lattes…
Clearly, this is a simplified version of what could happen. The money in Fred’s pension pot isn’t all technically his, as he will still have to pay tax on some of it, pension funds don’t manage themselves for free, and there’s no guarantee that he’ll earn five per cent interest every single year. It could even go down. And yet, It’s clear that by saving that extra money, Fred was able to build up a sizeable savings pot, whereas Phil doesn’t have anything. The money was worth around four times more in the future.
Getting the balance right
Now, we’re not saying you shouldn’t spend any money now whatsoever. That would be dull. After all, sometimes you need a holiday, or a celebratory meal out with your family, or some new clothing for a special occasion. Sometimes you just want to walk into your local coffee shop and buy whatever you want, because you want it and you can. Everyone needs to find their own balance between spending and saving.
But if you do choose to save that money, then know that the money will start working for you. The government will add a bit if you put it into a pension pot. And then some compound interest will boost it a little more.
Think of it as your very own cash snowball. You start out with a small snowball in your hand, but once you start rolling it along the snow on the ground, it gets bigger and bigger. With money, you start out investing a little, and the cashball slowly begins to grow. And at some stage, that ‘cashball’ is going to gather momentum and start rolling along all by itself, increasing in size as you add more money, but also increasing in size even if you don’t add any money as it constantly compounds.
Standing in line at the coffee shop isn’t probably the best place to start considering all of this. You’ll get some funny stares as you grind to a halt thinking of your future cashball. Instead, a quick chat with us is probably a better idea.
Make ours a mango latte, if you don’t mind.
This article is for general use only and is not intended to address your particular requirements. It should not be relied upon in its entirety and shall not be deemed to be or constitute advice.
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