Finance
Beating inflation over the long term: compound interest and tax efficiency
Global Banking & Finance Review®
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Warren Buffet famously afforded his fortune to his location, “some lucky genes, and compound interest”. For readers who aren’t aware, with an
Warren Buffet famously afforded his fortune to his location, “some lucky genes, and compound interest”. For readers who aren’t aware, with an estimated net worth of $110 bn, Warren Buffet is one of the richest people in the world and has been for decades – when it comes to making money, this is someone to take seriously. So, what did he mean by ‘compound interest’?
Well, far from being any arcane investor secret, compound interest is simply a mathematical process that involves reinvesting earned interest alongside the principal investment. Reapplying this process for a sustained period of time has the potential to generate considerable returns, although, as with any investment, risks apply.
But first, let’s return to basics. How do you earn interest? Whenever you lend money to an organisation, such as governments via gilts, companies via corporate bonds, banks via savings accounts, or peer-to-peer lending via an IFISA, you accumulate interest on top of your original loan.
Most people would have encountered this as a figure given as an Annual Percentage Rate (APR). For example, an APR of 10% means that after lending £1000, you would receive £1100 back at the end of the year, generating an earned interest of £100.
After receiving your £1100, you could either:
Applying the latter option is at the heart of compound interest.
The chart below highlights this exponential power. The figures show the enormous potential for returns merely by reinvesting the original £1000 alongside the interest earned each year. After 10 years, with an interest rate of 10%, you’ll have made an additional £1594.
Year Start of year investment Interest % Total at end of year 1 £1,000 10 £1,100 2 £1,100 10 £1,210 3 £1,210 10 £1,331 4 £1,331 10 £1,464 5 £1,464 10 £1,611 6 £1,611 10 £1,772 7 £1,772 10 £1,949 8 £1,949 10 £2,144 9 £2,144 10 £2,358 10 £2,358 10 £2,594
Furthermore, the greater the amount you can invest, the greater your potential for profit. Let’s take a look at what happens if you not only reinvest your earned interest but keep investing a further £1000 each year.
Year Start of year investment Interest % Total at end of year 1 £1,000 10 £1,100 2 £2,100 10 £2,310 3 £3,310 10 £3,641 4 £4,641 10 £5,105 5 £6,105 10 £6,716 6 £7,716 10 £8,487 7 £9,487 10 £10,436 8 £11,436 10 £12,579 9 £13,579 10 £14,937 10 £15,937 10 £17,531
After 10 years and a total investment of £10,00, you will have made an additional £7,531.
Applying this for another 10 years and the interest truly starts to deliver incredible returns.
Year Start of year investment Interest Total at end of year 18 £45,599 18 £50,159 19 £51,159 19 £56,275 20 £57,275 20 £63,002
Over 20 years, you’ll have invested £20,00 but made a profit of £43,000.
Nothing special is going on here. It really is pure mathematics. But, as we have demonstrated, it does take time until large earnings truly start to accumulate, and investors will no doubt be aware that interest rates can vary and potential for returns is subject to risk.
However, the principles of compound investment can go a long way in helping investors maximise their returns over the long term and mitigate high inflation rates.
Tax efficiency and compound interest
With the powers of compound interest laid bare, it’s now time to turn to another weapon – tax efficiency – one which is complimentary to compound interest.
Tax efficiency may sound complicated, but the general idea is pretty simple: it’s about using the various investment vehicles and tools available to minimise the taxation on your returns and asset values. Let us take ISAs (Individual Saving Accounts) as an example, which can enable savings and investments to grow tax-free.
They are particularly tax-efficient because they protect money from taxes that would otherwise have to be paid on both the income the investment generates and on any increases in the value of the asset itself. Most valuably, they also enable investors to compound tax-free returns.
There are many different types of ISAs, each made with a different target audience in mind. These include the ISA, the Lifetime ISA, Stocks and Shares ISAs, and Innovative Finance ISAs. Every year you can save or invest up to £20,000 in an ISA, choosing to select one form or spread it across many.
Cash ISAs are quite similar to traditional savings accounts and can be opened at almost every major bank across the UK. By depositing money into one of these, investors stand to benefit from an annual interest rate which closely mirrors the base rate set by the Bank of England.
While these ISAs are generally very tax efficient, typically interest rates in regular ISAs stand at around 3-4%. Currently, with inflation standing around the double-digit mark, this can make it very challenging for them to deliver real-term growth.
As the name suggests, Stocks and Shares ISAs allow savers to hold conventional forms of investments such as stocks and shares within an ISA. With their eponymous equities often varying so often, such accounts are subject to greater volatility.
Meanwhile, the Lifetime ISA is a longer-term tax-free savings account. Savers can put in up to £4,000 every tax year toward buying a home or retirement planning and the government will provide a 25% bonus on top of the savings. While this is generous, this account does come with several restrictions on the use of the savings and when the cash can be withdrawn.
Finally, Innovative Finance ISAs (IFISAs) are accounts that allow ordinary savers and investors to lend and hold more dynamic forms of finance such as peer-to-peer loans and debt-based securities.
IFISAs are classed as investments, and in large part, this is because they have the ability to generate higher returns (which are not subject to tax) than traditional saving methods. For example, average returns on IFISAs have ranged between 7% – 9% over the past 5 years, compared to the typical 3-4% you would expect on the Cash ISA.
Within the property sector, IFISAs have unlocked the ability for ordinary investors to participate in high-grade property investment opportunities via lending platforms and reap the benefits of tax savings on any returns they receive. As with any investment opportunity, risk levels vary from project to project and investors should select their options based on their own financial goals, investment objectives, and risk appetite.
With inflation presenting a great hurdle to generating real term returns, the combined powers of compound investment and tax efficiency offer investors a powerful tool to navigate the economic landscape. While such tools often work best over the long term, investors with patience will stand to gain the potential rewards.
Jatin Ondhia is Co-Founder and CEO of Shojin, an FCA-regulated online real estate investment platform that lowers the barriers to entry for individuals across the globe looking to access institutional-grade, UK-based real estate investment opportunities. He served as Director for UBS for nine years, using his wealth of knowledge and experience to provide strategic fixed-income solutions to the bank’s top clients and expand the UBS Delta businesses in the intermediary space. Jatin also has over 20 years of property investment experience.
Compound interest is the interest calculated on the initial principal and also on the accumulated interest from previous periods. It allows investments to grow at a faster rate over time.
A tax-efficient investment minimizes the tax liabilities on returns and asset values. Examples include ISAs, which allow investments to grow tax-free.
An Individual Savings Account (ISA) is a tax-efficient savings or investment account that allows individuals to save or invest money without paying tax on the interest or gains.
The Annual Percentage Rate (APR) is the annual rate charged for borrowing or earned through an investment, expressed as a percentage of the principal.
Inflation is the rate at which the general level of prices for goods and services rises, eroding purchasing power. It is typically measured annually.
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