What is Compound Interest?
Most of us have a basic understanding of interest and how it works. It’s a common factor that affects everything from the money in our bank accounts to the loans that we take out. It seems as though, for once, a financial element is simple and easy to master. Right? Not so fast. It turns out there are many different kinds of interest out there, and they all work in very different ways. Perhaps one of the most influential forms of interest is what’s known as Compound Interest. It’s a fairly normal influencer in the financial world but, even so, a lot of people are in the dark when it comes down to how it works and where you’ll find it. With that in mind, let’s ask ourselves a few important questions and familiarise ourselves with the subject. For instance, What is Compound Interest? How does it Work? And what are some examples?
Compound Interest is most easily understood as interest on interest. It occurs when previously accrued interest is reinvested and added to the principal (original) amount – making it larger. Then, after a compounding period has occurred, you will earn interest on this larger amount, thus increasing your earnings.
Right? Not so fast. It turns out there are many different kinds of interest out there, and they all work in very different ways. Perhaps one of the most influential forms of interest is what’s known as Compound Interest. It’s a fairly normal influencer in the financial world but, even so, a lot of people are in the dark when it comes down to how it works and where you’ll find it.
…ok, so maybe that wasn’t as simple as it could have been. But now that we’ve got a basic definition, hopefully, we can break it down further.
Compound Interest – Simplified
There are a lot of times in life when you receive interest in certain investments. Many people choose to withdraw these profits when they become available, but there’s another option to be considered.
Instead of taking out these returns, you can simply leave them where they are and allow them to grow further. Eventually, when it comes time to receive your next round of interest, the investee (the person or group that you gave your money to) will calculate your new interest based on your original investment plus the interest that has been accrued.
|In other words, as you reinvest the interest that you earn, the total investment amount increases. As this total increases, the amount of money you earn in interest will increase along with it. So long as you don’t take any money out, this amount will continue to grow – snowballing into a larger and larger investment that earns more and more money. Your interest compounds over time, thus increasing your returns.
If you’re still having problems, maybe a quick example will help clear things up.
What are some Examples of Compound Interest?
My favourite example of compound interest comes from the hit TV show Futurama –
- In the show, the main character, Fry, has a grand total of 93 cents in his bank account while living in the year 1999. By a strange twist of fate, he’s then cryogenically frozen and wakes up 1000 years in the future.
- Soon after waking up, Fry goes to the bank and tries to get his money back. The bank informs him of his original investment (93 cents) and the average interest that it has been subject to during his absence – roughly 2.25%.
- After some lightning-fast calculations, the bank teller informs Fry that he now has a total of $4.3 billion in his bank account.
As silly as this all seems, it’s actually a great example of how compound interest can snowball. Fry’s original investment was tiny, as was his interest rate. But over time this amount kept increasing with nobody around to make any withdrawals.
At first, the interest would’ve been barely noticeable, but once it got to around $1000, he would be earning around $22.50 each month. (Remember, his interest each month doesn’t stay at 2.25% of 93 cents. It increases with the total amount in the bank account, ie, it becomes 2,25% of $1000).
By the time Fry has $1 million in his account, he’s earning more on his compound interest than most people earn at their jobs.
Unfortunately, it’s not all good news. Compound interest can also work against you and can quickly get out of hand. For a more realistic example, let’s look at how compound interest can impact the average person –
- Let’s imagine someone uses their credit card to pay for some necessary purchase.
- The bank eventually requires them to start paying back the money, with interest.
- The person is unable to fully pay back the interest cost, let alone the total amount.
- This unpaid cost is then added to the total amount that’s owed.
- The next time the interest costs are calculated and the individual has to make a payment, the total loan amount has increased, and thus, the required interest payment has increased.
- Here’s where things get scary. If the person was unable to pay for last month’s interest, how will they be able to pay for this month’s interest now that it has increased? Here’s the thing – They can’t. The amount they need to pay keeps increasing each month and repayment becomes less and less feasible as time goes on.
What is the Difference Between Compound Interest and Simple Interest?
The main difference between simple and compound interest is that simple interest is only calculated on the principal and does not take compounding factors into account, in other words, Simple Interest is only the interest that you make on the original amount of money invested or loaned.
When calculating simple interest, we assume that any extra money earned is not being reinvested into the account. So, unlike compound interest which grows as time goes on (so long as money is not removed), simple interest remains the same.
Let’s look at another quick example to better understand this concept –
- A person invests a principal of R100 in the bank.
- The interest rate on their investment is 10%.
- They earn R10 per month via their interest.
- With compound interest, the compounding period would pass (let’s just pretend it happens each month) and they would begin earning 10% of a higher amount, ie, at the end of the next month, they would earn 10% of R110, which would give them R11.
- This amount would continue to grow as would the amount of interest they receive each month.
- With simple interest, however, the interest is only based on that original R100, so each month, the person will only be earning R10.
How can I Earn Compound Interest?
The main way to earn compound interest is to reinvest your money. While it would be nice to take out any interest you earn and treat yourself to something nice, it’s far more prudent to keep that cash where it is and allow it to grow further.
Additionally, you can search for investments that have frequent compounding periods. Different investments compound interest at different rates. Some can do it daily while others may only compound at the end of the year. The more frequent the periods are, the more money you’ll end up accruing.
Do Stocks Earn Compound Interest?
It depends. If you have invested in dividend-paying stocks, you can reinvest your earnings and buy more shares. In this sense, dividend-paying stocks can operate (at least in principle) as compounding assets.
What is the Importance of Compound Interest?
Compound Interest is an extremely useful tool to have if it’s working in your favour. Because it grows the money you make over time, it can end up having an incredible snowball effect on your earnings.
Beyond this potentially phenomenal growth rate, compound interest also makes your money ‘work for you’. Put simply, compound interest will continue to grow your money so long as you don’t touch it. This means that you can sit back and relax while your earnings continue to increase.
In Conclusion – What is Compound Interest and How Does it Work?
Compound Interest refers to the earnings you make when your interest is calculated based on your principal amount as well as your previously accrued interest. In other words, when you earn interest on an investment, instead of withdrawing it and spending it, the money is reinvested and added to the original amount that you invested. The next time your interest is calculated, it will be based on this newer, larger amount. Obviously, this will result in a larger interest payout which can then go back into your principal again and increase future earnings even more.
Compound Interest can be most easily understood when you compare it to Simple Interest.
In the case of simple interest, you would be earning interest on the principal amount alone, and thus, the amount you receive in interest would not increase each month.
- You make a R100 investment at 10% simple interest monthly
- 10% of R100 is R10
- R10 is then added to your account each month
By contrast, compound interest is calculated on the original amount plus the interest that you’ve made already.
- You make a R100 investment at 10% compound interest monthly.
- 10% of R100 is R10
- At the end of the first month you end up with R110
- In the next month, your interest is calculated on the R110 amount rather than the R100 amount
- 10% of R110 is R11
- At the end of the second month you will end up with R121
- This process continues and you end up earning more and more money each month so long as you don’t have any withdrawals
The above example does, however, assume that the compounding periods are taking place at the end of each month. These periods are the times at which the bank compounds the interest and begins to calculate further interest from the increased amount. It should be noted though, that each investment will have a different compounding period. Some compounding periods may occur daily, while others may only occur yearly. The more frequent the compounding periods are, the more interest you’ll end up accruing.
The easiest way to begin earning compound interest is to reinvest your money back into your compounding accounts. Each time you reinvest, your total amount grows. Each time your total amount grows, your interest earnings grow.
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