By Popular Investor Paulo Carvalho de Sa (@PauloGabrielSa)
You have probably heard about compound interest (or maybe you haven’t), so we will explain in this post what it is, how it grows your money, and the importance of being patient when investing long term.
Once in a while, we are faced with making financial decisions. These may involve anything from taking a loan from a bank to purchasing a house or a car; or investing money in bonds, stocks or other securities. Intelligent wealth management means borrowing and investing wisely.
Compound Interest is considered a wise investment strategy. Briefly, compound interest is the accumulation of interest over a previous period, based on the initial capital and all the deposits that were made over time. That results in reinvesting interest instead of withdrawing profits.
How Compound Interest Works:
The formula for calculating compound interest is: A = P(1+r/n)(nt)
- A = the future value of the investment
- P = the principal investment amount
- r = the annual interest rate (as a decimal)
- n = the number of times per year that interest is compounded per period
- t = the number of periods the money is invested for
Compounding has the effect of generating a larger accumulated amount. The effect is especially significant when the interest rate is high.
Compound Interest Quick Examples:
To better understand compound interest, first start with the concept of simple interest: you deposit money and the bank pays you interest on your deposit.
Seems complicated? Let’s simplify it with examples:
- Let’s suppose you start investing $100 monthly which will give you an investment of $1200 p/ year.
- With an annual interest rate of 10%, over a 20-year period.
- You’ll invest/deposit $24,000, earn $52,600 in interest, with a total balance of $76,600 over 20 years.
The beauty of this is that it has a snowball effect, so let’s say that instead of 20 years, you will invest for a 40-year period:
- $100 monthly
- 10% interest rate
- The total deposit will be $48,000, earnings of $590,000 in interest, with a total balance of $638,000 over 40 years.
Isn’t that crazy? How you can turn $48,000 into half a million? Well, there is one variable in this that screws everything up for most people: PATIENCE.
And also keeping an annual interest rate of 10% (which should not be hard).
When investing, long-term patience is the key to success. Investing long term is not a quick way to win money. It’s a slow, but reliable way to increase your capital (it becomes faster and faster if you are patient enough).
Compound interest is most useful for those who want to save money over a long-term period. Through regular investments, a savings account can grow to quite a large amount. When it comes to investing with compounding interest, you should start early. The younger you start saving and contributing, the more time compounding can work in your favour. You should also make regular and disciplined investments. By making saving for retirement a priority, you could end up with an excellent nest egg.
“My wealth has come from a combination of living in America, some lucky genes, and compound interest.” – Warren Buffett
What Makes Compound Interest Powerful?
Compounding happens when interest is paid recurrently. The first one or two cycles are not especially notable, but things start to pick up after you add interest repeatedly. Therefore, we can talk about the following aspects:
- Frequency: The more frequent the compounding periods — daily, for example — the more dramatic the results.
- Time: Compounding is more prominent over long periods. You’ve got a higher number of calculations or “credits” to the account when money is left alone to grow.
- Interest rate: Higher rates mean that an account will grow faster. But compound interest can overcome a higher rate. Particularly over long periods, an account with compounding, but a lower rate can end up with a higher balance than an account using a simple calculation.
- Deposits: Letting your money grow or frequently adding new deposits to your account is the best thing to do.
- Starting amount: The amount of money you start with does not affect compounding. Whether you start with $100 or $1 million, compounding works the same way. The earnings seem bigger when you start with a large deposit, but you aren’t penalised for starting small or keeping accounts separate. It’s best to focus on percentages and time when planning for your future: What rate will you earn, and for how long? The money is just a result of your rate and time frame.
Compound Interest — Bonus
Now, you don’t need to pick up the calculator and start doing the compound interest math. There are numerous calculators that allow you to calculate that more easily and quickly.
I personally use the free online interest calculator: https://www.thecalculatorsite.com/finance/calculators/compoundinterestcalculator.php
The author, Paulo Carvalho de Sa (@PauloGabrielSa) is an eToro Popular Investor from Portugal. He invests mainly in stocks, indices and crypto and believes that “patience is everything” when investing.
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