What is compound interest?
Compounding is process of continuous earning generation on initial investment over a period time. Compounding requires you to reinvest your earnings and time to have a exponential growth yields over a long investment period. In other words, it is called “compound interest” effect where your money keeps growing on itself.
Albert Einstein once said “The most powerful force in the world is compound interest”.
Okay so let’s break all that compound interest down to its roots so we try to understand why Einstein allegedly made such a claim.
There are many formulas to calculate compound interest available for many purposes. Here I just want to show the simplest form of the calculation to help you understand what it is and how it works over time.
Future Value = Present Value *(1 + i)^n
Future Value: Total amount you get after a compounding period
Present value: initial amount you invest in
i: Interest rate earned per year
n: numbers of compounding period = number of years x compounding frequency
What does this formula mean?
It means that the money generated by your initial investment or interest is making money on itself, just as the your initial amount is doing over years. We assume the interest rate stays somewhat the same during your investment period, the longer you invest – higher number of years, the higher the n, the more your money get multiplied.
Compound interest effect will do its best when you invest over 10 – 20 years period. Again, I want to emphasize the “time” factor really matters here.
Now, we look at how this effect actually looks like with numbers.
For example: you invest $17,000 to Bondora in 2017 with the interest rate 12% and you want to invest for 20 years. And we assume the interest rate is the same over this investment period, the compounding frequency is semi-anually, so interest is compounded 2 times a year.
Present value = $17,000
i = Interest rate = 0.12 (%)
n = number of compounding period = year x 2
Year 1: Future Value = 17,000*(1 + 0.12)^2 = $21,325
Year 5: Future Value = 17,000*(1 + 0.12)^10 = $52,799
Year 10: Future Value = 17,000*(1 + 0.12)^20 = $163,987
Year 15: Future Value = 17,000*(1 + 0.12)^30 = $509,319
Year 20: Future value = 17,000*(1 + 0.12)^40 = $1,581,866
We can see from year 10 onward, your future earnings will grow exponentially. Now we need to agree with Einstein that the force is strong with this one – compound interest.
The graph below shows the big difference between the normal interest (orange line) where you won’t make any cent on your earnings from the principle investment, and the compound interest effect (blue line).
For example you put money in a bank and every month you get 7% out of your bank and spend it or put it somewhere. Over the years, we have inflation and you see the money you get from normal, fixed interest rate grows a little bit. If you use it invest somewhere else and beats the inflation rate, good for you. Otherwise this money will go into the wind without the compound interest effect because you spend on something or has been defeated by compound inflation rate. In the end, what else you get?
Compound interest effect
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it”