In this first article we will discover what compound interest is and why it is very important for your investment success. We will also look at some examples to grasp the real power of compound interest and see which factors determine it.
The definition of compound interest
Basically compound interest is the term for additional interest you earn when you add the interest from one period to your principal investment in the next period instead of opting for a payout. So for example you start with 100$ at 5% interest rate and receive 5$ interest. In the next period your principal investment grows to 105$, so your interest at 5% would be 5.25$ (instead of 5$). The compound interest would be the 0.25$ that you only earnt because of adding your interest from the beginning back to the principal.
The key variables that determine compound interest are the principal investment, the interest rate, the compounding frequency and time. With interest rate and time being the most important ones.
This concept is one of the most important in finance, because it allows you to grow your investments exponentially (without having to do extra work). Even though exponential phenomena are difficult to comprehend for the human mind, there are multiple examples from other areas for example the growth of bacteria and nuclear chain reactions.
Visualization of the power of compound interest
In the graphic The Power of Compound Interest 1 you can see the exponential character of compound interest. You can also see how it unfolds over time and for different interest rates. Note the huge difference between an interest rate of 15% and 20% and that it is several times bigger than the same percentage difference between 10% and 15% interest. This means a small difference in interest rates can make a huge difference over a longer period of time. A return of 20% over the course many years was actually achieved by the world’s best investors and is not impossible. In the graphic The Power of Compound Interest 2 I zoomed in so you can better see the differences in interest rates and I also included the return of the S&P 500 for comparison.
The concept of compound interest is difficult to really understand, not intellectually, but to really get a feeling for its power and meaning. Hopefully I could convey its importance to you. If you liked the article or have some criticism feel free to leave a comment. Thank you for reading!