How Compound Interest Works and How to Use It

Jul 18, 2019 · 3 min read

Compound interest is the interest you earn on both your principal and previous interest. It means your investment returns don’t just grow linearly like 5 + 5 = 10; it grows exponentially like 5²= 25.

How does compound interest work?

Adeola, a young lady in her twenties, just learnt about compound interest in an investment class and decided to invest N100, 000 in a dividend-yielding stock that would compound over ten years. The annual dividend yield on the stock is 10%.

Why did she choose a dividend-paying stock? Adeola’s dad had once told her that these kinds of stocks provide a regular, steady stream of income — and she’s the type that wants an income-generating portfolio. Instead of cashing her dividends though, she wants to re-invest it and leverage on the power of compound interest.

“The power of compound interest the most powerful force in the universe,” someone said Albert Einstein had blurted out while talking to a colleague.

Adeola held her N100, 000 shares investment, and in the first year, she earned N10, 000 — the dividend payout by the company. Her principal for the second year is now N110, 000 (original investment of N100, 000 + N10, 000 dividend). She re-invested the whole of N110, 000 in the shares of this same company at the same dividend yield.

At the end of the second year, the company paid Adeola N11, 000 as her dividend. Now she has N121, 000 as her total money at the end of the second year.

Let’s imagine Adeola continues her disciplined approach to investing for the next eight years; also, assuming the company’s dividend yield remains at 10% every year.

Here’s what her investment would look like:

But what if Adeola didn’t listen in her investment class, only investing her principal yearly?

Here’s what she would look like in ten years without compounding compared to when she compounds her earnings:

What are the other effects of compound interest?

Though compounding interest could be powerful with building wealth, it has made many poor too.

When you take a loan that compounds monthly or yearly, your debt grows pretty fast. What happens here is you have to repay the principal and the interest that you incur that month or year.

Compound interest also applies to every other area of your life — the small daily effort to improve your relationships, professional network and health compounds to produce a much more powerful result in the long term.

How to leverage compound interest for your good

1. Have a long time horizon

Compound interest works best with a long term perspective to investment.

We only began to see Adeola’s compounded returns start to become massive in the fifth year. To gain the maximum advantage of compound interest, you have to invest consistently for a long time.

2. Watch closely the interest rate on your loans

Evaluate your loan document carefully to understand if the loan interest is computed in simple or compound interest. A high-interest loan compounded regularly can get you in trouble very fast.

Suppose Adeola took a loan instead of investing, with the same terms of 10% annually, at the end of 10 years the loan would have become oppressive.

3. Choose investments that compound frequently

Some investments compound daily, monthly or yearly. An investment that compounds often gives a slight edge to help your money grow faster.

But there’s a difference between an investment that compounds monthly at an annual interest rate of 10% and one that compounds 1% per month. The former with a yearly rate of 10 % only compounds at 0.83 % per month, which means the later at 1% per month is better.