What is compound interest?

Compound interest is an investment term that is often misunderstood, yet it can be one of the most powerful tools available to investors. Essentially, compound interest is the interest earned on both the principal amount and any accumulated interest from previous periods. This means that over time, the amount of interest earned can increase dramatically, leading to significant gains for investors.

Understanding how compound interest works is essential for any investor looking to grow their wealth over the long term. By reinvesting interest payments, investors can take advantage of compounding to achieve higher returns on their investments. In this article, we will explore what compound interest is, how it works, and how it can benefit investors.

What is Compound Interest?

Compound interest is a type of interest that is calculated on both the principal amount and any accumulated interest from previous periods. Unlike simple interest, which only calculates interest on the principal amount, compound interest takes into account the interest that has already been earned.

For example, let's say you invest $1,000 in an account that pays 5% interest per year, compounded annually. After the first year, you would earn $50 in interest, bringing your total balance to $1,050. In the second year, you would earn 5% interest on $1,050, which is $52.50, bringing your total balance to $1,102.50. Over time, the amount of interest earned would continue to increase, leading to significant gains over the long term.

Compound Interest Formula

While many of us won't use the compound interest formula (we will either have excel do it, or go to a tool like this one from NerdWallet) I'd still like to show you how to set it up just in case you are ever interested.

The formula:

P[((1+i)^n)-1] = the amount of interest you earn over the defined time period

P = principal

i = annual interest rate

n = number of compounding periods (normally you just do this in years)

Example:

Year 1 - you start with a $1,000 investment on January 1st and a 10% interest rate (that is a high rate, but is easy to round)

Year 2 - (1,000 * (1+0.10)^1) - 1

• (1+0.10)^1 -1 = .1

• 1,000 * .1 = $100 (this is the amount of interest you earned in year 1)

• $1,100 is the amount of money you will have on January 1st of year 2

Year 3 - (1,100 *(1+0.10)^1)-1

• $110 is the amount of interest you would earn in year 2

The graph below shows the growth over a 20-year timeline. With an initial investment of only $1,000, you would have over $7,000 and have done nothing more than sat back and watched your money grow!

How Does Compound Interest Work?

The key to understanding how compound interest works is to recognize that it is a snowball effect. As the interest earned is reinvested, it earns even more interest in the future, leading to exponential growth over time.

There are three main factors that determine the amount of interest earned through compound interest: the principal amount, the interest rate, and the length of time the investment is held. The longer the investment is held, the more time the interest has to compound, leading to higher returns.

The frequency at which interest is compounded also plays a role in the amount of interest earned. The more frequently interest is compounded, the faster the investment will grow. For example, an account that compounds interest daily will earn more over time than an account that compounds interest annually.

Benefits of Compound Interest

The primary benefit of compound interest is that it allows investors to achieve higher returns over the long term. By reinvesting interest payments, investors can take advantage of compounding to achieve exponential growth in their investments.

Another benefit of compound interest is that it can help investors reach their financial goals faster. By reinvesting interest payments, investors can achieve higher returns without having to contribute additional funds to their investments.

Compound interest is also a useful tool for retirement planning. By starting to save early and taking advantage of compounding, investors can build a significant nest egg over time, even with relatively small contributions.

Conclusion

Compound interest is a powerful tool that can help investors achieve higher returns on their investments over the long term. By reinvesting interest payments, investors can take advantage of compounding to achieve exponential growth in their investments.

Understanding how compound interest works and the benefits it can provide is essential for any investor looking to grow their wealth over the long term. With careful planning and a long-term investment strategy, investors can use compound interest to achieve their financial goals.