Compound interest is a financial concept that describes the effect of earning interest on an already existing sum of money, which is then added to the original sum

What Is Compound Interest? – Forbes Advisor Australia

An Introduction to Compound Interest

The financial world can seem intimidating at times with a seemingly complex procession of terms and concepts. Compound interest, however, is an integral component of the monetary sphere that anyone dipping a toe into the pool of finance must understand. Whether you’re planning to invest in a high-yield savings account or considering taking out a loan, understanding compound interest and its implications could be pivotal in making the most astute financial choices.

Compound interest refers to the concept of interest earning interest. It is the amount earned on both the initial money deposited or borrowed – known as the principal sum – and the interest that amount has already garnered. Consequently, compound interest is what makes an investment or a debt grow at a faster pace compared to simple interest, which only earns or costs money on the original principal.

Unlike regular interest, where your deposit or debt produces constant returns over time, compound interest results in exponential growth. Each compounding period — which can occur monthly, yearly, or at other intervals, chosen by you or your lender/investment provider— adds more to your initial deposit or debt. So, let’s dive in further.

Consider an investment scenario where you have $5000 in a savings account with a 5 percent annual interest rate compounded yearly. In the first year, you earn 5 percent on $5000, which amounts to $250. In the second year, you earn 5 percent on $5250 (your original amount plus the interest earned), adding $262.5 to your account. And so the process continues, snowballing each passing year.

• Your principal for the first year: $5000
• Interest earned in the first year: $250 (5% of $5000)
• Total balance at the end of the first year: $5250 ($5000 + $250)
• Your principal for the second year: $5250 (total from last year)
• Interest earned in the second year: $262.5 (5% of $5250)
• Total balance at the end of the second year: $5512.5 ($5250 + $262.5)

The Mathematical Formula Behind Compound Interest

The underlying engine of compound interest is a mathematical formula that governs its work. This formula, often referred to as the compound interest formula, provides a systematic method to calculate the future value of an investment or the total cost of a loan given specific variables.

In its simplest form, the compound interest formula appears like this:

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

Where:
– A represents the future value of the investment/loan, including interest.
– P stands for the principal sum (initially invested/borrowed amount).
– r is the annual interest rate in decimal form (so 5 percent becomes 0.05).
– n indicates the number of times compounding occurs per year.
– t signifies the time the money is to be invested or borrowed for in years.

So, if we ventured back into the previous example but this time using the formula to determine your account balance after two years:

• Initial principal amount (P): $5000
• Annual interest rate in decimal (r): 0.05 (5% / 100)
• Number of compounding periods annually (n): 1 (compounded annually)
• Total number of time in years money will be compounded (t): 2
• Apply these into our formula, it’ll result to (A): $5000 (1 + 0.05/1)^(1*2) = $5506.25
• So, utilizing the compound interest formula indicates that your balance, after two years at 5% compounded annually, would total $5506.25.

Brief History of Compound Interest

The concept of compound interest may sound like a modern invention, but in reality, it traces back thousands of years into history. The ancient civilisations understood the power of compound interest, although not exactly in the way we do today.

Records from Babylon and Egypt hint at establishing a very basic form of compound interest, where a grain outstanding would breed more grain, leading to an ever-increasing debt obligation as time passed. Fast forward to the middle ages; Europeans used rudimentary compounding principles in their financial transactions, which led to the birth of the banking industry as we know it today.

For instance, during the reign of Roman Empire, financiers or ‘money lenders’ often offered loans with yearly interest. A borrower taking out a loan of 1000 denarii at 10 percent per annum would owe 1100 denarii after one year. If the loan were to be unpaid, another 10 percent interest would be tacked onto the new total, making it 1210 denarii following the second year.

• Initial debt (P): 1000 denarii
• Annual interest rate (r): 10%
• Debt at end of first year: 1100 denarii (1000 + 10% of 1000)
• Interest added for the second year: 110 denarii (10% of 1100)
• Debt at end of second year: 1210 denarii (1100 + 10% of 1100)
• This shows us that the principle of compound interest was in existence and use even back in ancient times.

Significance of Compound Interest for Investors

Compound interest can be an investor’s best friend. It comes into play when investing in assets or financial instruments like stocks, bonds, mutual funds, and retirement accounts. Because it can significantly increase the value of investments over time, understanding how compound interest operates is foundational knowledge for any investor.

Albert Einstein reputedly referred to compound interest as the “8th wonder of the world,” further stating, “He who understands it, earns it; he who doesn’t, pays it.” The importance of compound interest in investments is well-illustrated using the concept of ‘time value of money.’ Essentially, this principle asserts that a dollar today is worth more than a dollar tomorrow because the dollar today can earn interest.

The farther out the investment horizon, the more potent compound interest becomes. Suppose you invested $10000 in a bond with a 6% annual yield, compounded annually for 30 years. Look how your initial investment grows:

• Principal amount (P): $10000
• Annual interest rate (r): 6%
• Number of years (t): 30 years
• Total earning after 30 years: $10000 * (1 + 0.06/1)^(1*30) = $57,434.98
• The power of compound interest in this case means your $10000 investment would balloon to a whopping $57,434.98 over 30 years!
• This illustrates the strong incentive for early investment wherein investors can put compound interest to work and watch their wealth grow exponentially.

Impact of Compound Interest on Loans

However, while compound interest can be fantastic for investments, the flip side is also true. When borrowing money, compound interest has the exact opposite effect on your finances. It makes your debt grow faster and, over time, could add a significant burden unless you keep up with payments.

Whether it’s for a mortgage, car loan, student loan, or credit card debt, the impact of compound interest can make a considerable difference to the total amount you end up paying back. The longer your loan term and the higher your interest rate, the more interest you will pay over the life of the loan.

Let’s consider an example of $10000 borrowed at an annual interest rate of 6% compounded annually for 10 years:

• Principal debt amount (P): $10000
• Annual interest rate (r): 6%
• Number of years (t): 10 years
• Total debt balance after 10 years: $10000 * (1 + 0.06/1)^(1*10) = $17908.49
• This indicates that without any additional repayments over 10 years, a $10000 loan will expand to over $18000!
• It’s no wonder wise financial advice always dictates paying off your debts as quickly as possible to limit the adverse effects of compound interest.

Frequency of Compounding

The frequency with which interest compounds crucially affects the total amount of compound interest earned or charged. This could range from annually, quarterly, monthly, daily, or even continuously. Generally speaking, the more frequently compounding occurs, the greater the overall amount of compound interest.

For instance, if you were investing $10000 in a 5 year term deposit at a bank offering a fixed annual interest rate of 2%, but one bank offers yearly compounding while another offers daily compounding. Although the difference might not seem large, over time, compounded daily will result in slightly more interest.

When comparing the two:

• Principal investment amount (P): $10000
• Annual interest rate (r): 2%
• Number of years (t): 5 years
• Total value with yearly compounding: $10000 * (1 + 0.02/1)^(1*5 ) = $11040.81
• Total value with daily compounding: $10000 * (1 + 0.02/365)^(365*5 ) = $11051.27
• The difference may not be massive, but it illustrates how compounding frequency can affect your returns or loan repayments subtly.

Strategies to Maximise Compound Interest

As we’ve discussed above, compound interest can build wealth or unintentionally create debt; it’s all about how you use it. For investors and savers, a few strategies could help magnify the benefits of compound interest.

Firstly, start saving and investing early. The earlier you invest, the longer period your money has to compound and grow. Secondly, consider reinvesting your returns. By plowing your gains back into your investment, you increase the base amount that compounds over time. Finally, choose accounts with higher interest rates and more frequent compounding periods. This increases the overall amount of compound interest you earn.

Suppose you decide to start investing early in a retirement fund such as a superannuation account with a 7% annual return when you’re 21 instead of 31:

• Initial investment at age 21: $5000
• Annual contributions: $2000
• Rate of return: 7%
• Value of investment when retired at 65, if started at 21: $1,119,000
• Value of investment when retired at 65, if started at 31: $489,383
• This demonstrates the significant advantage in starting your investments early!

Conclusion: Power of Compound Interest

All in all, compound interest is an incredibly powerful tool and understanding it holds the key to smart financial decisions. For investors, it can help multiply your gains over time setting you onto a path of financial abundance when wielded correctly. However, borrowers need to be extremely cautious, as this same magic tool can merrily turn around causing debts to inflate quickly.

Therefore, familiarise yourself with how compounding works, frequently review your finances to ensure your investments are maximizing your potential returns, and your debt repayments are restricting the expanding influence of compound interest. Past the jargons and equations, educating on the power of compound interest brings a little more order to your financial universe.

In a scenario where you have a $5000 initial investment and a fixed annual interest rate of 5% for 20 years:

• If compounded annually, total gains will amount to $13266.64
• If compounded semi-annually, total gains will amount to $13340.50
• If compounded quarterly, total gains will amount to $13401.17
• If compounded monthly, total gains will amount to $13449.56
• If compounded daily, total gains will amount to $13467.29

It’s a perfect demonstration of the magic that is compound interest, reinforcing the mantra: The more often it compounds, the better! So go ahead, let this magic work in your favour and watch your money grow faster than you ever thought possible.