What Is Compound Interest?

Compound interest is the principle that money you earn today adds up over time, and it’s a powerful tool for building wealth. It can be used to help you save more money or invest in something that will make your money grow faster. On the other hand, compound interest can also work against you if you don’t take action immediately. If you want to learn how to use compound interest wisely, keep reading!

Compound interest rate is often associated with the annual interest rates of some financial vehicle. This could be a credit card, stocks and shares, real estate etc. To learn more about the power of compound interest checkout the rest of this post.

If you want to quickly work out some compound interest values, checkout our calculator here!

What is so Powerful about Compound Interest?

In simple terms, compound interest means that the amount of money you have grows at an exponential rate. For example, let’s say you start with £1,000 and invest it into a savings account earning 7% per year.

After 40 years you would have £16,440.23 where over £1000 in interest was gained in the 40th year alone. In other words, your gains speed up the more money you have invested.

This also works negatively on if your debt is building due to a high interest rate. Payments just get higher and higher. This is why many financial enthusiast suggest that high interest debt should be the first area to focus on eliminating/improving. 

So what does all this mean? Well, it means that compound interest is one of the most powerful tools available to us when it comes to saving and investing. Let’s look at how it works

Compound Interest vs Simple Interest

Simple interest is calculated on the same principle as simple multiplication. The difference however is that with compound interest the interest earned is added onto the original amount. This allows the interest earned to grow over time which is why it is considered to be a much stronger form of interest than simple interest.

In order to calculate compound interest all you need to do is multiply the interest rate by the total amount invested. However if you want to know how much you will have after a certain number of periods then you must use the compound interest formula instead.

How to Work Out Compound Interest

Compound Interest can be worked out using the compound interest formula:

A = P(1+r/n)^nt

• P = principal amount invested
• r = interest
• t = number of years
• n = number of times the interest is compounded each period.

 Breaking it down

The compound interest formula above gives us an overall value at the end of the specified number of periods but how exactly does compounding speed up the growth of values. Below is a breakdown of what happens between each year of a calculation using a starting balance of £100, an annual rate of 10% for 10 years. For the purposes of this example so that the calculations are clear we are only compounding the interest rate once each period (n = 1)

Year 1

Start Balance = £100

Interest Gained = 10% of £100 = £10

Final Balance = £110

Year 2

Start Balance = £110

Interest Gained = 10% of £110 = £11

Final Balance = £121

Between year one and two the difference becomes clear. Because of the interest gained in the first time period is acting in addition to the start balance of year 2, the interest gained in year 2 gains an additional £1. If we illustrate through to year 10, this difference becomes more and more apparent

Year 3

Start Balance = £121

Interest Gained = 10% of £121 = £12.10

Final Balance = £133.10

Year 4

Start Balance = £133.10

Interest Gained = 10% of £133.10 = £13.31

Final Balance = £146.41

Year 5

Start Balance = £146.41

Interest Gained = 10% of £146.41 = £14.64

Final Balance £161.05

Year 6

Start Balance = £161.05

Interest Gained = 10% of £161.05 = £16.11

Final Balance = £177.16

Year 7

Start Balance = £177.16

Interest Gained = 10% of $177.16 = $17.72

Final Balance £194.87

Year 8

Start Balance = £194.87

Interest Gained = 10% of £194.87 = £19.49

Final Balance = £214.36

Year 9

Start Balance = £214.36

Interest Gained = 10% of £214.36 = £21.44

Final Balance = £234.82

Year 10

Start Balance = £234.82

Interest Gained = 10% of £234.82 = £23.48

Final Balance £254.35

As you can see by year ten the yearly growth rate has increased from £10/year to £23.48 per year while not putting in any extra money. As soon as you begin adding regular deposits into your investment or saving accounts the growth increases even further. 

Longer time periods often yield better results for investments due to this compounding effect. Although to help improve earnings, having a good initial investment is sure to help returns in the future.

The Pros and Cons of Compound Interest

Pros:

• You will be more secure financially because you have built up a large sum over time.
• It helps build wealth over long periods of time which allows you to save for retirement or other goals.
• The longer you invest with compound interest the higher the return on your investment.
• There is no real limit to how much you can make

Cons:

• It can take a long time for the benefits of compound interest to show.
• Compound interest can increase the risk of losing money as assets can go down in value.
• When you do make money through compound interest you will have to pay taxes (There are legal ways around this)

Summary

To summarise , compound interest works by taking the initial deposit and multiplying it by a percentage figure which is then added to the original deposit every time it compounds. The more money you put in the faster the growth will be. This allows you to grow and more importantly preserve your length long term to hopefully help support a long retirement.

It can either work for you or against you depending on whether you have assets or liabilities experiencing compound interest. High interest debt can cause problems because if you don't pay off the loan quickly enough you could find yourself with a large sum of money owed to someone else that is continuously growing.

If you enjoyed this blog create an account with us as there is much more content to come very soon. Once again feel free to check out our compound interest calculator to play around and see the power of compounding:

Click here for the Compound Interest Calculator

Thanks for Reading 😊

FAQ

How to Use the Compound Interest Calculator?

Just click the link to checkout our calculator and fill in the different fields on the page. If you then click calculate, you will get a breakdown of the compounding on either a daily, monthly or yearly breakdown. You can also change the starting balance and number of years to see what happens.

What Is a Simple Definition of Compound Interest?

Compound interest refers to the phenomenon whereby the interest associated with a bank account, loan, or investment increases exponentially rather than linearly over time. The key to understanding the concept is the word “compound.” Suppose you make a $100 investment in a business that pays you a 10% dividend every year. You have the choice of either pocketing those dividend payments like cash or reinvesting those payments into additional shares. If you choose the second option, reinvesting the dividends and compounding them together with your initial $100 investment, then the returns you generate will start to grow over time. (investopedia.com)

What is the “Rule of 72”?

The Rule of 72 is a financial rule of thumb to roughly estimate how many years are required to pass for the value of an investment to double. The rule relies on fixed interest rates, and the result is not entirely accurate. The Rule of 72 works by dividing 72 by the annual rate of return (as a whole number). For example, the Rule of 72 says it will take 14.4 years for an investment at 5% return to double (72/5). The exact time could vary based on compounding frequency. The Rule of 72 becomes less accurate as the rate of return rises with returns over 20% becoming unfavourable for the method. (learn.robinhood.com)

Why Should I Care About Compound Interest?

Compound interest is a tool accessible by everyone, and if you use it correctly it can bring you great wealth. If you ignore it, it will eat away at your life in the form of high interest debt. Even if your not interested in becoming wealthy, it is likely a good idea to not let debt get the best of you.