What is compound interest? Compound interest is according to Einstein, is the 8th wonder of the world and the most powerful force in the universe. It can make small initial investments grow into huge amounts of money if the investing horizon is long enough.
How does the compound interest work?
Compound interest works pretty much like this: Your investments grow interest, and after the interest is added to the initial capital, the interest starts to build interest itself. Some examples below.
Let’s say you invest 1000 dollars today. After one year, your investment has grown 10%, making it 1100 dollars. After one more year, your investments have again grown 10%, but this time the 10% wont be just from the initial 1000 dollars; it will be from 1100 dollars.
This means you gain interest on your initial capital and on the interest you earned last year. Your 1000 dollars gains again 100 dollars and the last years 100-dollar interest gains 10 dollars. So after the second year, you don’t have 1200 dollars; you have 1210 dollars.
That might not seem like much, but over the long term, this effect will be huge. Compound interest can be applied to other things as well, not just investing, but now we are going to focus more on the investing side.
Two examples with pictures below. On the chart, the blue line represents your capital, if you withdraw all the interest as soon as you get them. The orange line represents the effect it will have if you reinvest the interest. In this example, we used 10% annual returns.
As you can see, the effect of compounded interest is huge. When withdrawing your earnings, you would after 30 years have 4000 dollars from your 1000-dollar investments.
That is not so bad either, but comparing that to what compound interest would have gotten us, that’s not so great anymore. If you reinvested your earnings and let compound interest work, after 30 years, you would have almost 17 500 dollars.
Compound interest over a 50-year period
The effect will be much bigger if we add 20 years to that timeline. On a 50-year period, the difference is HUGE. Check out the chart below.
Reinvesting your earnings, from 1000 dollars with 10% annual return, your investment would have grown to over 117 000 dollars. Compare that to the 6000 dollars you would have if you withdrew the interest, there is a huge difference.
As we can see, the longer the investing horizon is, the larger the effect of compound interest will be. That is why you should start your investing journey as young as possible, to get the best out of compound interest. I have a post about how investing can make you rich. You can read it here.
How can you benefit from compound interest?
You can benefit from compound interest yourself. It is not difficult nowadays to open an account that offers index funds and ETFs, for example. You can even invest into straight stocks if you have the time and motivation to do your research about them.
Index funds are the more beginner-friendly way to go. They are a pretty passive form of investing, since you don’t have to follow the prices actively.
There can be big differences between funds as well. The effect the fees of the fund can have on your investments in the long term can be huge. More about how fees can affect your returns, you can read here; it is a post comparing active funds with passive funds over a long period of time.
Final words / summary
This was a short post on what compound interest is. I hope the examples help you understand the effect it can have on your investments if you invest long enough.
In summary:
- Compounded interest grows interest to your initial investment as well as the previously paid interest.
- The longer the investing horizon, the more effective compound interest will be.
- Fees can eat a big chunk of your earnings.
Hopefully this was helpful to you, have a nice day.
This is not investment or financial advice. Past returns are not a guarantee of future returns. Always do your research before risking your hard-earned money.