Today I am going to talk to you about the compound interest. I will explain you what it is, how you can use it to your advantage, and overall, how it can make you rich. Once you finish reading this article you will realise that Compound Interest is your best friend. Let’s begin!
What is compound interest?
I have already told you about it in the requirements to financial freedom post, but today I am going to dig into it in more detail. Hopefully you will realise how important it is. Einstein defined it as follows:
Compound interest is the most powerful force in the world. It is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.
Well, if a genius like Einstein gives such a strong statement, maybe it’s time for us to start paying attention to it. But it doesn’t end up here. Another well known genius, which is widely considered the best investor of all times, said:
The single most powerful factor behind my investing success is Compound Interest
Guess who he was? Yeap, you got it, Warren Buffett. So when the man who has accumulated 82 Billions investing in stocks says that the key to his success is the Compound Interest, you definitively need to start understanding how it works.
Compound Interest – Definition
On Wikipedia it’s defined as the addition of interest to the principal amount, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out.
Basically it means that the interest generated by an investment over a period of time is added to the initial invested amount, so in the next period it will produce an increase in the interest generated by the investment.
There are two main types of interests, simple and compound. The simple interest means that the profits are not reinvested the following period. Due to this, the amount of money obtained from the investments will always be the same.
On the other hand, when you use compound interest, you reinvest your profits. As a result, the interest obtained on the next year increases. This happens every year, creating a wonderful loop where the money increases without limit!
When you apply compound interest to your investments, your money will multiply forever. Horray!
How to calculate the Compound Interest with the Equation
Let’s take a look at the Compound Interest formula:
- A = future value, including principal and interest
- P = principal amount
- r = annual interest rate
- n = number of times the interest is compounded
As you can see on above formula, the future value of your portfolio will be determined by the initial amount (P), the annual interest rate (r) and the number of years (n).
But don’t worry, you don’t need to start doing your own calculations on a paper.
Thanks to internet, there are tons of calculators that make your life easy. By the end of this article I will show you the one I use, just stay with me for a little bit longer 🙂
I would like to highlight the importance of time here. Time is the key factor in order to get the most out of the compounding effect.Time and Compound Interest are best friends, so you have to keep them together as much as possible. The compounding impact gets bigger as the time goes by. So, for it to show its full power, you need to reinvest your profits over many years.
Compound Interest Examples
Now it’s time for me to show you how truly powerful this tool is. If Einstein and Warren Buffet words above were not enough to convince you, let me draw you a example that I hope will!
Going to an imaginary world, we have Jorge and Flavio. Both have an initial capital of 100,000 euros. They are both avid investors, so they have invested all their capital into the S&P500 Index. They are getting a 10% annual return, since this is the average S&P500 return over the past 150 years.
Jorge likes to reduce his risk by lowering his exposure to the market, so every year when he gets his profits, he transfers them to the bank account.
Flavio, on the other hand, is aware of the wonderful effect of compounding the interest, so he reinvests his profits every year.
Results of reinvesting your profits (compound interest)
The table below highlights the differences in capital over time for Simple Interest strategy (Jorge) and Compound Interest (Flavio)
|Simple Interest - Jorge||Compound Interest - Flavio|
|Year||Initial Amount||Interest Earned||Final Amount||Initial Amount||Interest Earned||Final Amount||Difference|
After 10 years Flavio has accumulated 59,000 euros more than Jorge. But let’s not stop here.
Moving forward in time, on the year 20, we can see that Flavio has now 372,000 euros more than Jorge. Flavio has now a net worth than more than doubles Jorge. The story is not over yet.
10 years later, they are both quite old 😀 30 years have gone by, and compound interest has shown all its power. While Jorge is sitting at 400,000 euros, Flavio has 1,745,000. Just by reinvesting its profits Flavio has earned 1,345,000 euros more, 1.3 million difference!
I believe now you can see the full strength of the compound interest.
Since one picture is worth more than a thousand words, let me illustrate you with below graph that shows the difference between compounding the interest and using simple interest.
You can see that on the first years there is barely a difference. But after some years, Compound Interest starts to show its benefits. As the time goes by, the growth is exponential.
It’s not possible to get rich in 3 years, you need to be patient. But as you become more patient and allow the compounding effect to take place, you will see that you will be highly rewarded!
Compound interest and periodic contribution
We have see on the previous example the wonders of reinvesting your profits over many years. We saw that Flavio, starting with an initial capital of 100,000 euros, after 30 years had ended up with 1.74 millions. Just by getting 10% returns on his investments and by compounding his profits.
If we go to the calculator that I use (just a little bit more and I will show it to you), we can confirm above results
Now, let’s see the impact of being able to add money every year to our investments. If we are able to save 10,000 euros per year (833 euros per month), let’s see the effect it has in our future net worth.
On the picture above we can see that by adding 10,000 euros every year, we will achieve 3.55 millions. This is means that we end up having the double amount than if we had not being able to save.
Let me highlight once more the importance of compounding your profits.
- If we don’t add any periodic contribution, after 30 years we have 1.81 millions
- If we add 10,000 euros every year, after 30 years we have 3.55 millions
- By adding 10,000 euros every year during 30 years, we have put a total of 300,000 euros
- Our total Net Worth difference is 1.81 millions (3.55 – 1.74 = 1.81 millions)
By adding 300,000 euros we have earned 1.81 millions more! How can this be possible?
This huge increase in the earnings is due to the Compound Interest
This is another great example of how much reinvesting your profits can help when you are trying to accumulate wealth.
Compound Interest Calculator
The moment you have been waiting for has arrived! Below you can find the Compound Interest Calculator. Thanks to TheWealthyFinn for developing and sharing it!
It’s very easy to use. Just set the initial amount of money you have, the monthly contribution, the number of years and the annual return you will get.
Play with it, and see how your financial future will be!
I hope by now it is clear that compound interest will help you to become rich, you just need to give it time so it can do its work and earn money for you!
Yes, it’s true that increasing your monthly contribution will help speeding things up. But still, the key factor will always be time.
It doesn’t matter if you are investing in stocks, bonds, peer to peer lending, or real estate. What matters is that you always reinvest the profits as soon as you have them, and that you are patient enough for the Compound Interest to play his magic 🙂
If you are planning on reaching Financial Freedom, you need to have the certainty that Compound Interest will be your best pal on this wonderful journey.
More posts related to investing
If you want to learn more about compound interest and investing, I recommend you the following posts:
If you have any question, please feel free to ask on the comments section below.