1+1 Equals 2.1 or How Compound Interest Works
It might sound like a sleazy fake guru thing to say but bear with us, it will make total sense.
Introduction
You probably heard the term in abundance in the last 2 years. Everyone started investing, so the media content creators followed the trend and nowadays we have the biggest number of investing gurus in history (probably, there is no statistics on it). Some of them really emphasize the importance of compound interest. And they are correct about it. But why?
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What is compound interest?
There isn’t a magic formula to make money. There just isn’t. But compound interest is the closest thing. It is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods. It can be seen as an “interest on interest”.
How does it work?
We’re gonna keep things very simple and straightforward. Let’s say you have a initial deposit of $100. That is your principal. You create a portfolio that manages to return 10% a year and you commit to holding it long term. The return is the interest.
So, at the beginning (Year 0) you have $100 principal with $0 interest. After the 1st year passed and your portfolio returned 10%, you now have $100 principal + $10 interest (10% of 100=10) totaling $110. Here comes the interesting part. Starting with the 2nd year, the 10% return applies not only to your principal of $100 but to the total sum (principal + interest) that becomes the “new principal”. That gives us $121 and not $120 because of the compound interest.
Year 0: $100 principal | $0 interest | $100 total
Year 1: $100 principal | $10 interest | $110 total
Year 2: $110 “principal” | $11 interest | $121 total
Year 3: $121 “principal” | $12.1 interest | $133.1 total
Year 4: $133.1 “principal” | $13.31 interest | $146.41 total
With this technique, by year 8, the yearly interest with surpass your initial investment ($114.36 in interest on a $100 investment). This is just a simple example. You can play around with different variables like initial investment, daily/weakly/monthly/yearly contributions to the principal, return, rate of withdrawal, etc. We encourage you to try some awesome compound interest calculators we found on Google (linked below) — no affiliation. If you don’t like our recommendations you can find one for yourself. Just search for “compound interest calculator” and have some fun with it.
Negative aspect
As always, there is the other side of the coin. Compound interest can work against you in the same manner, in case of negative return, so keep that in mind.
Disclaimer
If this article stirred up your interest (pun intended), please understand we do not claim to offer financial advice, we are here to try and educate people so they can do further research and make better decisions for themselves.
