How does compound interest work?
Discover the mechanism and power of compound interest, considered the eighth wonder of the world. It is important to understand how it operates and how to optimize its benefits, especially in cryptocurrency space like DeFi where interests are important.
Table of content :
- Definition
- The power of compounded interest
- Calculation
- APY vs APR
- Conclusion
Definition
Compound interest represents the interest on a loan or deposit that takes into account the initial principal and the accumulated interest from previous time periods.
Compound interest can be represented as “interest from interest”. It grows faster than simple interest, which is computed only on the original balance.
Interest can be compounded at any interval: ongoing, daily, weekly or annually. The more frequently it is compounded, the greater the difference with simple interest will become.
The power of compounded interest
Compounding interest allows you to shift from a constant linear growth to an exponential growth. Time is an important factor, the longer the compounded investment, the more it diverges from the non-compounded investment.
Compounding is considered a powerful tool for investors seeking to optimize the management of their income or wealth.
Warren Buffett became one of the world’s wealthiest men through a strategy of patiently compounding his returns over extended periods of time.
Compounding is a long-term vision-based process. Significant results will only appear after a certain time.
This is the reason why Warren Buffett earned most of his net worth after he turned 60.
Concretely?
Imagine being able to fold a sheet of paper 42 times on itself. How thick would it be?
The human mind is used to linear thinking and has trouble interpreting this situation. This same linear thinking restricts our understanding of the true potential of compound interest.
In fact, the thickness of the folding would be equal to the distance from Earth to Moon and reflects the power of compound interest. From the thickness of a 0.1 mm paper sheet, to several hundred thousand kilometers (384,000 km) in only 42 foldings.
Calculation
The rate at which compound interest accumulates depends on the frequency of compounding. The greater the number of compounding periods, the greater the compound interest.
The formula is the following:
Let’s take an initial investment of $1000, compounded monthly at an annual rate of 12% for five years.
With compound interest, we have :
Without compound interest, we get :
By compounding monthly the interest, we end up with a value gap of 216.70$.
This difference is even more prominent in the cryptocurrency and DeFi ecosystem, where interests can rise to three figures.
APY vs APR
Returns and interests rule all protocols in the DeFi environment. The terms APY and APR are often mistaken by users.
However, this difference has a major influence on your portfolio, as interest works linearly on one hand and exponentially on the other.
The APY considers compound interests that are reinjected into the protocol, in order to generate incremental interests.
The APR does not take into consideration compound interest.
Most protocols promote their APY in order to display higher rates. However, in most cases, you have to compound the interests yourself to achieve these percentages.
There are DeFi protocols that allow to automatically compound the interests, in order to optimize the “gas” fees. Beefy Finance is an example.
Conclusion
Albert Einstein described compound interest as “the eighth wonder of the world and the most powerful force in the universe”. Today, interests rule the different protocols in DeFi, where each user is looking for the best rate to fructify his investments.
An accurate understanding of how they work is a significant advantage in taking profits and an essential asset in shaking up our financial outlook.
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