Compound interest “is interest calculated on the initial principal, which also includes all of the accumulated interest of previous periods of a deposit or loan […] it can be thought of as “interest on interest”, and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount“.
Compound interest is calculated by multiplying the principal by one plus the annual rate of interest raised to the number of compound periods minus one. The “miracle effect” of compounding is possible because the calculation takes into account all of the accumulated interest of previous periods. The more frequently the compounding occurs, the more interest you will accrue.
Compound interest =
Total amount of principal and future interest minus present principal
HOW COMPOUNDING WORKS AGAINST YOU
Jim takes out a 10-year loan of $1000 at an annually compounded interest rate of 3%.
After 10 years, Jim will have paid his bank:
$1000 [(1+0.03)^10 – 1] = $1343.92
If the bank had applied simple interest, Jim would have paid:
$1000 [1+(0.03 x 10)] = $1300.00
Through the simple power of compounding, Jim paid his bank an extra $343.92.
This is known as the cost of compounding.
HOW TO USE THE COMPOUNDING EFFECT TO YOUR ADVANTAGE
The beauty of life is that whatever works against you can also work for you. The best way to grow your money using the compound effect is by reinvesting the money you earn along with the money you started out with.
One common way investors compound their investments is through dividend investing.
Dividends compound when they are reinvested into purchasing more shares of the dividend stock. As the number of shares owned grows, so do the dividend payments, allowing the investor to purchase even more shares. After a period of time, the number of shades owned grows to the point of generating a continually reinvested dividend stream.
This simple yet effective investment strategy can generate significant returns if implemented correctly. The key is consistency.
Example: an initial investment of $1000 growing at a compounded annual rate of 5% for 25 years, generates a total return of $3,386. The same investment of $1000 with a simple interest rate of 5% would only yield $2,250 after 25 years.
DOUBLE YOUR INVESTMENT: THE RULE OF 72
The rule of 72 is used to estimate how long it takes for compounding to double your investment: Simply divide 72 by your investment’s yearly interest rate. This rule, although not always exact, only works for interest rates below 20%. It is a useful method to get a general idea of expected returns.
Example: You expect a 5% annual return. The rule of 72 concludes that it will take a little over 14 years for your investment to double (72/5=14.4). This calculation is only valid if you compound your returns or distribution.
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Disclaimer: This is not financial advice. Do your own research before investing in any asset.