Interest, Inflation, and Compounding: What’s the Deal?

Let’s face it - Covid took us and our finances through the wringer. And are you also thinking: "I've heard the word inflation so many times it’s basically burned into my brain!" But what does it actually mean, and why should you care?

Here’s the thing: to grow your money and reach financial independence, you need to understand two key players—compounding and inflation. One is your financial bestie; the other, not so much. Let’s break it down!

Compounding: The Snowball That Keeps Rolling ☃️

You’ve heard of interest, right? Maybe not in the nicest way - like when it’s tacked onto your credit card bill or student loans. It’s that pesky amount that keeps getting added onto your bill because that's the interest you pay because you borrowed money.

Now, let’s flip this around. Compounding happens when you are the one getting paid, based on the money you’ve saved or invested. And here’s where it gets fun: as your savings grow, so does the amount of money being added to it. Think of it like a snowball rolling downhill—it picks up more snow as it rolls, making it grow faster and faster.

Saving: The Basics of Compounding 💸

Let’s say you put £10,000 into a high-yield savings account with a 5% annual interest rate. If you don’t touch it, after the first year, your balance grows to £10,500—that’s £500 interest earned!

But wait, it gets better. The next year, the interest isn’t just calculated on your original £10,000—it’s based on the new total of £10,500. So, you earn £525 in year two, bumping your balance to £11,025. Every year, your money earns interest on both the original amount and the interest you’ve already gained. After ten years you reach £16,289.

This is the magic of compounding—it’s your money working harder for you, and all you have to do is sit back and let it roll.

Investing: The Power of Compounding on Steroids 🚀

Historically, the stock market has delivered average annual returns of about 8-10% (before inflation). That’s nearly double what you’d get from a high-yield savings account. Let’s look at the same £10,000, but this time, you invest it in an index fund averaging an 8% annual return:

Year 1: £10,000 grows to £10,800
Year 2: £10,800 grows to £11,664
Year 3: £11,664 grows to £12,597
Year 10: £10,000 balloons to £21,589

By year 10, you’ve more than doubled your money - and all you had to do was let it sit and grow. Over 20 or 30 years, this growth becomes even more jaw-dropping, thanks to the snowball effect of compounding returns.

Inflation: The Sneaky Villain That Eats Your Cash 🛒

Now, let’s talk about why compounding is so important. Enter inflation - the silent villain in your financial story. Inflation simply means that prices go up over time.

For example:

In 1955, £100 had the purchasing power of about £2,678 today.
Translation: the same amount of money buys less and less as years go by.

Inflation is why your grandparents could buy a house for £20,000, but today you can barely find a parking space for that price. It chips away at your money’s value, which means your cash in a regular savings account (or worse, under your mattress) is actually losing purchasing power over time.

Now, other than the fact that we all love free money, why is compounding so important? Because of that pesky word from before – inflation. Inflation just generally means the increase of prices over time. While inflation rates fluctuate (as evidenced by the past few years adjusting to the Covid economy), the impact is a price increase over time. That’s why the purchasing power of $1 million in 1950 is equivalent to about $13 million today. Because inflation decreases our money’s purchasing power over time, we need something to combat that – enter compounding! Compounding is how you ensure you not only grow your wealth, but do so in a sustainable and inflation-proof way.

How Compounding Fights Inflation Like a Pro 🥊

This is where compounding becomes your superhero. As it's how you ensure you not only grow your wealth, but do so in a sustainable and inflation-proof way. By growing your money at a faster rate than inflation eats it, compounding helps you not just keep up but actually stay ahead.

Let’s revisit that £10,000 in a high-yield account earning 5% interest. Even if inflation is averaging 2-3% per year, your money is still growing faster than inflation can devalue it. That’s how you build sustainable wealth over time.

The Bottom Line: Start Small, Think Big 🚀

Compounding is like planting a money tree - the sooner you start, the bigger it grows. Whether you’re saving £10 or £10,000, the key is to get started now. The earlier you begin, the more time compounding has to work its magic and outpace inflation.

So, the next time someone mentions interest or inflation, you’ll know what’s up. Compounding is your ticket to growing your money, beating inflation, and building the future you deserve. Now, go roll that snowball and watch it grow! ☃️

Want to know what this means for you and how to get started? Download Aila - Your Money PT to learn more about investing. You don’t have to do this alone.

Thank you to Caroline Teare for contributing this blog. 🫶💫

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