Compound interest is the interest that is charged on the initial investment amount, as well as on interest accumulated in previous periods. Compound interest involves the reinvestment of income received.
Albert Einstein called compound interest the eighth wonder of the world, noting that those who understand compound interest earn it, those who do not understand it pay it.
How compound interest works
Compound interest works like a snowball: investments generate income, which in turn is also invested and creates new additional income.
To get the effect of compound interest on your investments, additional strategies or special economic knowledge are not required. It is enough to reinvest income, and not spend it. Today, interest capitalization is actively used in the banking sector and in the securities market (stocks, bonds, ETFs).
Compound interest can also be used in real estate, when rental income is used to buy and rent new properties.
Compound interest formula
There are a large number of resources on the Internet that offer the client to automatically calculate the capitalization. These compound interest calculators save a lot of time. However, if you want to get a thorough understanding of how interest capitalization works, it's best to calculate your investment returns manually.
The formula for calculating compound interest is as follows:
In this expression, we have five variables:
- A is the value of the total sum.
- P is the value of the initial capital.
- r - interest rate for the year, in some cases, the value that the investor expects to see. For example, a bank deposit interest of 7%, or an average dividend yield of 5%.
- n — frequency of interest accrual per year. The parameter indicates the number of accruals. If this happens monthly, then the value of the parameter will be equal to 12, if the accrual is made every two months, then the parameter will be equal to 6.
- t is the time period for which the person decided to realize his investment. Calculated in years. For example, an investor bought a bond for a period of six months (t = 0.5) or opened a bank deposit with a minimum maturity of one year (t = 1).
Example of calculating compound interest
Let's say a client opened a bank deposit for $100,000 at 10% per annum. The investment period is 5 years. Under the agreement, there is also the right to withdraw interest from the deposit every year.
How much can you earn in the end? There are two approaches to generating profit:
- Simple interest rate. Every year, the investor will withdraw all accrued interest from the account and spend it on his own needs.
- Compound interest rate. The investor does not withdraw interest. The accrued income is reinvested and brings even more profit.
The investor's annual return on investment in the first year is $10,000. If you regularly withdraw interest, then in 5 years the client will earn $ 50,000 in net profit. Is it possible to earn more? Can. If you do not withdraw interest, then the profitability of the deposit will increase every year, since the accrued interest will be reinvested and generate new income. In this case, after 5 years, the investor will earn $61,051 already.
After 5 years, the difference in real terms will be $11,051. Thanks to interest capitalization, the investor will be able to earn not $50,000, but $61,051 of net profit. This example shows that over the long run the effect of compound interest is clear. The longer you reinvest, the more you can earn.
In addition to the banking sector, interest capitalization is also actively used in the stock market (stocks, bonds, cryptocurrencies, ETFs). After all, profit reinvestment is an effective tool that allows many professional market participants to achieve significant results even without complex financial strategies and smart trading algorithms.
The main goal of all investors is to get the maximum return on their investments. This can be achieved in different ways. But the easiest way is to reinvest your earnings. The compound interest mechanism allows the investor to earn much more at a distance, all other things being equal. This approach will allow you to increase capital in the long term and achieve financial goals faster.
