What is compound interest?
The interest on a loan is calculated on both the initial amount and the accumulated interest from previous periods, and therefore enables investors to accumulate wealth over time. Compound interest is particularly beneficial for young people who have a longer time horizon who will receive large returns in the long run if they take advantage of it. This is one of the reasons many investors are so successful.
KEY TAKEAWAYS
- Compound interest is the interest on a loan based on both the initial principal and the accumulated interest from previous periods
- It allows potentially quite small amounts of money to grow into large amounts over time and is an alluring financial mechanism for investors
- It is particularly beneficial for young people who have a long time horizon to reap the long-term rewards of compounding interest
- The difference between simple interest and compound interest is that when calculating simple interest, you don't add the interest of previous years into the calculation of the new interest amount
How to calculate compound interest
Let's take a look at an example of compound interest!
You invest $1,000 and where you have decided to invest has an interest rate of 5%. This means that every year (or day, or month!) 5% of what you have invested, will be added to your investment. At the end of the first year, you receive interest of $50, which is added to your investment. For the second year, the amount of interest you receive is based on $1,050. At the end of your second year, you receive interest of $52.50, again this is added to your investment. For the third year, the amount of interest you receive is based on $1,102.50. At the end of the third year, you receive interest of $55.12, which will be added to your investment which would then be $1.160,62. You get the picture!
Difference between simple and compound interest
The difference between simple interest and compound interest is that when calculating simple interest, you don't add the interest of previous years into the calculation of the new interest amount. If we use the same example as before, but this time using simple interest, then the interest would be $50 every year so after 3 years the amount would be $1,150, you would therefore after just 3 years have $10,62 - and for every year the difference will increase.
Why is compound interest preferable to simple interest?
Compound interest really is amazing. It allows potentially quite small amounts of money to grow into large amounts over time. However, to see this growth and take full advantage of the full power of compound interest, investments must be able to grow for the long term. If you invest $1,000 tomorrow, then $1,000 in a year, and continue doing that for 30 years, with an interest rate of 8%, in 30 years’ time you could have a pot of $113,283. That’s $83,283 earned in interest!