What is compound interest

So, what is compound interest? Compound interest is a catch phrase that is so often used in the financial world of investments and savings, and whilst its actual meaning may not be obvious to everyone outside of finance, it is fairly easy to grasp once you understand the principles, and importantly, it can have a very significant and positive impact on your finances!

However, when understanding what compound interest is, you must also be aware that it can work in reverse if you carry debts so beware. Please see the section at the end of this article for more on compound interest and debts.

Compound interest is often described as the long term saver and investors best friend. It simply means earning interest on interest, and has been described as the eighth wonder of the world.

When considering the question of what is compound interest?, you need to understand the basic principle means that as well as earning interest on your capital and any additional savings and investments you make each and every year, there is also a certain element of your overall gains that are produced by earning income on the interest or dividend payments of previous months and years, and whilst the effect of compound interest can look quite insignificant in the very early years, it grows exponentially like a snowball in the latter years.

Once you have been investing and reinvesting for several decades, this element of your compound interest can be very significant indeed.

The longer the time period involved, the more accumulated interest can grow, and earn more interest on interest and so on. If you can just imagine that you held a monthly equity income fund for several decades and each and every month an income distribution was paid and the following month a little bit more was earned on that distribution, and then the following month a little bit more was earned on both the previous distribution and the second distribution, and then carry that principle on for 12 distributions per year, over 10 years would be 120 distributions and over 20 years would be 240 distributions, each and every one of them getting slightly bigger than the last because you are earning interest upon interest.

The ultimate outcome after many many decades of investing, can be a very significant sum indeed, and certainly worth learning all about what is compound interest?

What is compound interest example

As an example, If I had £1,000 at the start of year one, and earned 10% per year on that sum, at the end of year one I would have £1,000 + £100 of interest.

If that interest was then reinvested, I would now have £1,100 at the start of year two. The same 10% rate of return would then generate £110 of interest in the second year. The extra £10 being interest on the interest.

At the start of year three, I now have £1,210. A year later, using the same 10% rate of return, I have now earned £121. Some of this is interest on interest, and another slice is now interest on interest on interest!

The compounding effect is particularly powerful over decades of investing, and a significant part of your overall final return will have been effectively created from thin air, otherwise known as interest on interest. This is why it is essential to know what is compound interest.

If we take another look at the previously seen investment growth table as set out below. 40 years worth of £250 per month contributions, is the equivalent of £120,000 paid in. However, the value of the 10% growth column after 40 years, shows a figure of £1,581,019. This means circa £1.46m has been created by investment growth and the wonders of compound interest.

If the investor in our example table was able to generate an average return of 15% per year, then after 40 years, their pot would be worth a staggering £7.75m! And even more amazingly, most of that has again been created by compound interest.

Calculating compound interest

For anybody who is interested in the technical detail of how compound interest works, then the formula for calculating compound interest is P = C (1 + r/n)nt – where ‘C’ is the initial deposit, ‘r’ is the interest rate, ‘n’ is how frequently interest is paid, ‘t’ is how many years the money is invested and ‘P’ is the final value of your savings.

Instead of understanding these equations, you can just find a compound interest calculation tool online which is far easier than doing it yourself.

What is compound interest in reverse - warning

Be warned though, compound interest can work in the opposite way if you are in debt. Instead of you earning interest on interest, your bank will be earning it, and you will be paying it if you don’t keep up with your debt repayments.

This is why so many people get in trouble with debt when they only pay either the minimum amount per month or nothing per month off their credit card. Each month the bank adds a bit more interest onto it and so the debt gradually builds up month after month year after year until it becomes an unmanageable sum and leads to all sorts of problems for the debtor.

Albert Einstein was reported as saying “He who understands compound interest earns it, he who doesn’t, pays it.”

As someone mastering the art of financial literacy, you will fully understand what is compound interest, and make sure it works for you and not against you.