The Power of Compound Interest
3 minute read
Compound interest is the interest earned on an investment calculated based on both the initial invested amount and the accumulated interest earned over time. Otherwise known as interest on interest, compound interest makes your money grow faster than simple interest, which is interest calculated only on the initial invested amount.
Time in the Markets Beats Timing the Markets
In the world of investing, individuals that are most successful in accumulating wealth over time share similar values. Arguably, the most important of them is the idea of starting to invest sooner rather than later. Why is that?
By starting to invest earlier, you can take advantage of the compounding interest effect. Compound interest (or interest on interest) is the interest an investor can get based on their initial investment as well as the accumulated interest from all previous investment periods. As compound interest includes interest accumulated in previous periods, it can grow at an ever-accelerating rate over time.
What’s this interest on interest you are talking about? Let me illustrate with an example. Suppose I invest €1,000 in an account that promises to pay 10% interest every year. In one year, my account will earn €100 interest, bringing my investment to a total of €1,100. Simple, right? The magic of compounding interest happens after the first year. In the next year, the 10% interest will apply on the €1,100, which is what I have in the account already. Therefore, the interest earned two years from today will be €110, bringing my total investment to €1,210. Next year, the 10% interest will apply to €1,210, equalling a yearly interest of €121, bringing my total investment to €1,331, and so on.
With this example, it is easily understood that over time, this can have a significant effect on your wealth. Therefore, the more time your money is invested in the financial markets, the more rapidly you are likely to accumulate wealth with compound interest doing the work for you.
Other than the percentage rate of interest, the compounding frequency plays a significant role in wealth accumulation.
In our previous example, we used a compounding frequency of 1 year. This means that interest is added to your investment account every year. However, the compounding frequency can be different than one year, with the most common being monthly, quarterly (every three months) and semi-annual (every six months). Again, let’s illustrate with an example.
Suppose you invest €1,000 for one year. The interest rate is 12% per year. The compounding frequency is annual (every year). The interest earned by the end of the year will be €120. Suppose now the compounding frequency is monthly. This effectively means you earn 1% interest each month, so every subsequent month, you earn interest on interest. By the end of the year, you will have received a total of €126.83 in interest. It seems a small difference, I know, but this difference is magnified over time if we stretch this to 10, 20 or even 50 years down the line.
For those of you interested to see how all these numbers are computed, you can visit this site.
Start Early, Be Patient
Compound interest is arguably one of the most powerful tools at your disposal for building wealth over time. It is a concept that gives hope to investors of any size that, with the right combination of smart investment decisions and time, they can grow their wealth and support their desired future lifestyle.
By starting to invest early, you maximise the benefits you can get from the magic of compound interest. Having patience is also key in achieving your financial goals. Keep your money invested, as withdrawing money from your investment accounts prohibits the effect of compound interest from taking place. Use your knowledge of this wisely and let time and compound interest do the heavy work for you.
For those of you interested in playing around with a compound interest calculator, you can visit this site.