Compound interest: what is it?

Glossary

What is compound interest?

If you want to grow your wealth without having to keep an eye on how the markets move every day, then compound interest might be for you. Compound interest ensures that you not only receive interest on your original deposit, but also on the interest you have already earned. But what exactly is compound interest? And how can you calculate compound interest? In this article, you will get answers to these and other questions.

Not a BUX investor yet? Create your account

Compound interest: a definition

Compound interest is interest that is calculated not only on your original investment, but also on the previously earned interest. This means that you get interest on interest, and that effect grows with time. Other terms for compound interest are ‘compounding interest’, ‘compound interest’ and ‘compounding’.

How does compound interest work?

Compound interest works as follows: every time the interest is paid out, it is added to your initial investment, giving you a larger amount to calculate interest on next time. This is also known as the ‘interest-on-interest effect’.

You can see compound interest as a snowball effect: on the mountain, the snowball is small, but as the ball rolls down, it gets bigger and bigger. The longer the slope of the mountain is, the bigger the snowball becomes. In other words, investing for a longer period can potentially provide more effect.

An example to calculate compound interest

Imagine that you invest €10,000 with an annual interest of 5%, which is compounded monthly. After the first year, you have €10,500. In the second year, the interest is not calculated on €10,000, but on €10,500. This effect becomes stronger every year. The more often the interest is compounded, the faster your wealth can grow.

The interest-on-interest effect: the pros and cons

Compound interest has a number of clear advantages, but also some points of attention that you must take into account. In the table below, you will find an overview of the advantages and disadvantages.

The advantages of compound interest

The disadvantages of compound interest

Growth (compounding): Due to the interest-on-interest effect, your wealth can grow faster and faster as time progresses. This makes it ideal for long-term investments.

Time is essential: The effect of compound interest is less noticeable in the short term. You must be prepared to invest in the long term.

Consistency is rewarded: If you consistently deposit an amount monthly now, you can grow your wealth in the long term.

Knowledge is required: The concept of compound interest is simple, but without the right knowledge, this strategy can be a challenge to understand.

Potential for maintaining purchasing power: Due to the interest-on-interest effect, your wealth can grow faster. This helps you maintain or increase your purchasing power, provided the annual return is higher than inflation and costs.

Magnifies effect of losses: Compound interest works both ways. With negative returns, it can lead to a faster decrease in value. Diversification of your portfolio is a strategy to reduce the risk.

Suitable for different goals: You can use compound interest for various financial goals, from pension savings to building wealth.

Profit can be reduced: Factors such as inflation, taxes, and costs can lower the return.

Does not happen automatically: With some investment products, you can automatically reinvest, but not with all of them. You are therefore sometimes responsible for reinvesting yourself.

What is the difference between compound interest and simple interest?

The main difference between compound and simple interest is that with simple interest, the interest is always calculated only on the original principal sum. Compound interest, on the other hand, is calculated on both the principal and the interest that has already been earned.

An example of compound vs. simple interest

In the course of time, the difference between compound and simple interest becomes larger. Imagine that you have invested €1,000 at 5% interest per year.

With compound interest, you receive €50 interest after the first year. Your new balance is then €1,050. In the second year, the interest is calculated over €1,050, so you receive €52.50. After five years, you have earned €1,276.29.
With simple interest, you also receive €50 interest after the first year and have a balance of €1,050. In the years following, you receive €50 per year. After five years, you have earned €1,250.

The difference of €26.29 may seem small, but the difference becomes larger over time.

What is the formula for compound interest?

Calculating compound interest is simpler than it seems. The basic formula for compound interest is:

A = P(1 + r/n)^(nt)

The meaning of the elements:

A = the final amount of the investment, including interest.
P = the initial investment, the amount you start with.
r = the annual interest rate in decimal form.
n = the number of times per year that the interest is compounded: annually, semi-annually, quarterly, monthly, or daily.
t = the time the investment remains in place in years.

How do you calculate compounding interest?

You can calculate compound interest with the previously mentioned formula. Let’s take the previously used example for this (€1,000 deposit at 5% interest). The interest is compounded monthly and you lock the amount away for the next ten years. This means your possible final amount is the following:

€ 1000 (1 + 0,05/12) ^ (12 x 10) = € 1647,01

In addition to the formula, there are also handy tools online that simplify complex calculations.

The rule of 72: a formula

The rule of 72 is a handy rule of thumb that helps investors estimate how long it might take to double their investment, based on the annual interest rate. To do this, you simply divide 72 by the interest rate. The rule of 72 works best for interest rates between 6% and 10%.

The formula is:

72/r=Y

The meaning of the elements:

r = the annual interest rate

Y = the number of years to double your investment

An example of the rule of 72

Imagine that the interest is 5% per year. You then estimate that it takes 14.4 years to double your investment (72 / 5 = 14.4 years).

Why is compound interest important for investing?

Compound interest is a useful investment strategy for building wealth, especially for long-term investors. If you start investing early, the interest-on-interest effect can help you build wealth in the long term. Even small contributions can have an impact. Albert Einstein even called compound interest the eighth wonder of the world.

Not a BUX investor yet?
Create your account in a few minutes and start building your wealth.

Investing involves risks. You can lose your investment.

All views, opinions, and analyses in this article should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.