Compound Interest

Fundamentals - Lesson 6

3 minute read

By Panayiotis Kakourides

Hello again! Today, we’re going to learn about compound interest. It’s a simple idea that can help your money grow faster over time!

Key Takeaways:

Compound interest helps your money grow quicker.
Time and patience are key to maximising compound interest.
The compounding frequency affects your investment returns.
Understanding compound interest is crucial in making informed investment decisions.

Understanding Compound Interest 📈

Think of compound interest as a snowball rolling down a hill. As it rolls, it gathers more snow and gets bigger and bigger. When you invest money, you earn interest on your initial investment. Then, you also earn interest on the interest you've already gained. This is the magic of compound interest. It allows your money to grow faster over time.

Time and Patience ⏳

To use the power of compound interest, two key factors are time and patience. The longer your money is invested, the more it can grow. Like planting a seed and watching it grow into a tree, your investments need time to mature and grow. So, starting as early as possible and being patient is crucial to maximising your returns.

Real-World Applications 💡

Imagine you invest €1,000 at an annual interest rate of 10%:

Year 1: You earn €100 in interest. This brings your total to €1,100.
Year 2: This time, you earn interest on your initial €1,000 and the €100 in interest you already earned. This brings interest earned for this year to €110, bringing your total to €1,210.
Year 20: By now, you’ve enjoyed the power of compound interest for two decades. You still only invested €1,000 out of your pocket, but the interest you earn in this year alone would be about €487 (10% of €4,870, which would be your balance at the start of year 20).

As you can see, the amount of interest you earn each year increases over time because you’re earning interest on the interest from previous years, not just on your initial investment. This is the power of compound interest!

Compounding Frequency 📆

How often interest is added to your investment account can greatly affect your returns. This can happen yearly, twice a year, every three months, every month, or even every day. The more frequently interest is compounded, the faster your investment grows.

For example, if you invest €1,000 at 12% interest per year, it will become €1,120 at the end of the year. If the interest was compounded monthly (i.e., 1% per month), at the end of the year, you would have €1,126.83. This seems like a small difference, but over many years it can have a sizeable impact on your investment.

Conclusion 🏁

Compound interest is a powerful tool to help you build wealth. By starting early and being patient, you can make the most out of your investments. Now that you understand compound interest, you’re one step closer to reaching your financial goals.

In our next lesson, we’ll learn about building your portfolio. Stay tuned!