Compound interest is at the core of investing. It’s what makes your investments grow to considerable amounts over time. So understanding compound interest is important to invest successfully.
What is compound interest?
Compound interest means that the interest earned on the original capital over a given period is reinvested with this capital in the subsequent period to generate additional interest.
How compound interest works
Imagine you deposit €1,000 in an investment that returns 5% per year. After 1 year, you will earn €50 (5% of €1,000), and you're left with €1,050. The following year, you again earn a 5% return. But this time it won't be just on €1,000, but on €1,050. So instead of earning €50, you earn €52.50. You earn interest on the interest (which is why it's called compound interest). The following year, you earn 5% on €1,102.50, and so on...
The table below shows the interest you earn for the first five years. As you can see, the interest you're earning is growing every year!
How to calculate compound interest
Use the calculator below to experience how compound interest really works.
Why compound interest is crucial for investing
Compound interest is a fundamental concept in investing and is often referred to as the "eighth wonder of the world" due to its powerful effect on the accumulation of wealth. Unlike simple interest, which generates earnings solely on the principal, compound interest accrues on both the principal and the previously accumulated earnings. Over time, this leads to exponential growth of money.
When you're saving, the exponential growth of compound interest will significantly boost the total return on savings or investments. Even if you save a relatively low amount every month, the effects of compounding can lead to substantial growth over the long term.
Compound interest in practice: your savings account vs investing
We can show the power of compound interest by comparing the returns of a savings account to investing. You'll see that the difference is staggering! And it will likely make you question if the savings account really is the best place for your long-term savings (we're not talking about money you need on the short-term).
Let's imagine Nathan and Alice, two 20-year olds. They decide to put away €100 every month. Nathan puts this money in a savings account at his bank, yielding a return of 2% per year. But Alice decides to invest it. Because the value of her investments fluctuate, her return will not be the same every year. But on average, she will earn a 8% return per year.
Between the ages of 20 and 65, they will both have contributed €54,000 to their savings. But Nathan's savings will have grown to €87,000, whereas Alice's will have grown to a staggering €527,000! This difference of €440,000 is the power of compounding.
By investing her money and earning a higher return, Alice can compound her savings much more quickly than Nathan. And by investing her money rather than keeping it on a savings account, she can afford a much nicer retirement, at least financially.
Prepare for your financial future thanks to compound interest
It's very unlikely that the savings account will help us reach our financial goals. Instead, good investing is a way to leverage compound interest and prepare ourselves for our financial future. We don't mean risky investments like crypto, or individual stocks. Instead, we suggest broadly diversified, index-based ETFs. You may even call that type of investing boring. But we think good investing is boring.