Compound Interest and Tax Efficiency: Two Tools Every Investor Needs to Fight Inflation

Compound Interest and Tax Efficiency: Two Tools Every Investor Needs to Fight Inflation

Fight Inflation

By Jatin Ondhia

Perhaps the most famous investor in the world, the self-made multi-billionaire juggernaut Warren Buffet once attributed his vast wealth to a product of compound interest. But what exactly did he mean by this? 

Despite the secrecy often associated with investor tactics, Warren Buffet was simply pointing us in the direction of some fairly basic mathematics. 

Compound interest is the process of reinvesting any money you earn from interest alongside your principal investment. The key thing to remember is that compound interest works better over the long term– reapplying the above process has the potential to yield significant returns over time, although as with any investment, risks apply and thorough due diligence must always be observed.

But let’s not get ahead of ourselves. Firstly, what is the difference between simple interest and compound interest? Simple interest accumulates only on the principal balance you have deposited or invested, whilst compound interest occurs when you add the earned interest back into your principal balance.

The yearly interest generated by a sum that’s charged to borrowers or paid to investors is usually given as an Annual Percentage Rate (APR). For instance, an APR of 10% would mean that after lending a person or organisation £1000, at the end of the year, you would receive back £1100, making £100 in earned interest.

Upon receiving this, you could either: 

  • Reinvest the original £1000 and spend the £100 as earnings
  • Reinvest the total £1100 

The latter option is the principal argument of compound interest. 

The table below shows the potential for returns that can be accrued over the long term. After 10 years, assuming a constant 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


Now let’s suppose that you not only invest your earned interest but you keep investing a further £1000 every 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 investing £10,000 over 10 years, you’ll have made a potential profit of £7,531.

As mentioned at the beginning, compounding enables wealth to grow exponentially over time, and it’s in the latter years when profit margins stand to make a bigger impact. Let’s take a look at what happens if you reapply this for another 10 years. 

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


After 20 years, you’ll have invested £20,000 and potentially gained £43,000 in profit. 

No fancy stock analysis, no insider trading secrets – this is the power of mathematics. And while it is in the longer term that the power of compound interest really begins to take effect, the potential for returns is unmatched. Of course, interest rates can vary, and as with every investment, risks must be carefully evaluated, but as a general principle, compounding can be an effective way of maximising the value of returns and mitigating the eroding impact of inflation.

Tax efficiency – don’t pay more than you need to

Another powerful tool that should be on investors’ radars is tax efficiency, and it can be particularly potent when combined with compound interest. 

Tax efficiency is about effectively using the different investment vehicles and allowances at your disposal to minimise the impact of tax, subsequently, maximising returns. 

Individual Saving Accounts (ISAs) are one such vehicle that enables savings and investments to grow tax-free. Within these, investors can save or invest up to £20,000 tax-free each year, which can be used in one ISA account or spread across many. They not only protect against taxes that usually would have to be paid on the income the investment generates (interest) but also for what would be due on any increase in the value of the asset itself. Most importantly, they allow investors to compound tax-free returns. 

There are many different types of ISAs, each with its own benefits. These include the Cash ISA, the Lifetime ISA, Stocks and Shares ISAs, and Innovative Finance ISAs. 

Cash ISAs can be opened at most major banks across the UK and operate in a similar way to normal saving accounts. When an investor deposits money into one of these accounts, they stand to earn interest at a rate which closely follows the base rate set by the Bank of England. Although interest rates vary, regular cash ISAs generally offer around 3-4% per year. In the present high-inflation environment, the potential for generating real-term growth can be challenging.

Meanwhile, Stocks and Shares ISAs allow users to hold more conventional assets such as stock and shares. The drawback with such accounts, of course, is that these assets can often be very volatile.

A Lifetime ISA is a longer-term saving account with tax-free benefits. Every year, savers can deposit £4,000 tax-free, providing it is toward buying a home or retirement planning. In return, the government provides a further 25% bonus on top of the savings. 

Last but certainly not least are Innovative Finance ISAs (IFISAs). These accounts allow ordinary savers and investors to lend funds via more dynamic forms of finance such as peer-to-peer loans. 

Typical returns on these accounts have performed comparably well. Over the past 5 years, average returns on IFISAs have ranged between 7% – 9%, compared to 3-4% typically found on Cash ISAs. 

IFISAs have been transformative in the property sector, allowing ordinary investors to participate in high-grade institutional investment opportunities, via lending platforms.

As inflation continues to evade efforts to control it, investors are presented with a very real challenge of ensuring their assets grow in real terms. Compound interest and tax efficiency provide investors with two tools to navigate this challenging economic climate. While they may, indeed, take some time to realise their full power, harnessing their combined potential could go a long way towards protecting wealth from the eroding factors at play.

About the Author

Jatin OndhiaJatin 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.

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