What is Compound Interest?

If you’re an investor – or anybody interested in growing their wealth, for that matter – you can’t help but get excited by compound interest. We all want to see our balance grow with the minimum of effort, and compound interest makes that a reality. Imagine: seeing your wealth get bigger and bigger, without you having to lift a finger – who wouldn’t want a slice of that in their lives?

For investors, it simply doesn’t get much better than compound interest. Here at Wealthface, we know it’s something our clients love to hear about… so if you’re new to the concept, pay close attention. Compound interest is based on the principle that your interest earns its interest. It gets better, though: The interest you earned on the original interest also earns interest… and then that interest goes on to earn its own interest, and the bigger your balance, the higher those interest figures become. Are you interested in interest? You should be!

Simple vs Compound Interest

If you’re a little confused by that explanation (and we wouldn’t blame you if you were; it’s not the easiest thing to explain in writing), let’s look at how compound interest compares with simple, everyday interest. Let’s say, for example, you have $1000 in your bank, and they are offering you a 7% interest year on year. With simple interest, your balance sheet is going to look something like this: At the end of the first year, you’ll have $1000 plus $70 of interest, giving you $1070 total. At the end of the second year, you’ll have $1070 plus another $70 of interest… taking you up to $1140. Year three would bring yet another $70, and you’ll then have $1210. You get the picture – you’re receiving $70 each calendar year.

Now, if we look at a compound interest system, you’re going to notice something quite different. Remember: the interest you’re earning is also going to earn its interest. So, in the first year, you’ll have $1000 plus your 7% interest: $1070. In year two, however, your interest will be 7% of $1070 ($74.90), giving you a total of $1144.90. Year three? Well, that’s going to be $1144.90, plus 7% of that sum, which will give you $1225.05. Even if you’re not the hottest mathematician, you should be able to see those figures going up and up, and that’s the direction every investor wants their wealth to take!

The benefits of Compound Interest

From that example, it should be clear what the primary benefit of compound interest is: it makes you a whole lot more money than simple interest does. If you want to get technical about it, you can look at something called the law of 72. It states that if you take the number 72, then divide that by your annual interest rate, it will give you the number of years it would take you to double your money… without having to deposit or contribute any more funds whatsoever. So, to use the example we’ve just gone through, if your interest rate is 7%, you could double your wealth in 10 years. How about that for a tempting idea?

Logic, therefore, states that the sooner or earlier you get involved with compound interest, the higher the benefits will be. Quite simply, the more you deposit, the more compound interest you will receive – it’s a snowball effect, gathering speed, size, and value with every year. It’s not necessarily even every year; some compound interest accounts operate on a monthly, weekly, or even daily basis, meaning your wealth can grow even more quickly!

Factors to be aware of

While compound interest has clear benefits for those actually earning the interest, the flipside of the coin has some definite downsides. If you owe money, the same compound nature of these accounts can quickly snowball in the other direction.

Just look at credit cards, for example. If you didn’t pay off your bills (and we’re sure you always do, right?), the following would happen:

In the first year, let’s say you owe your credit card $2000. With a 19% compound interest rate, you’d end up owing $2380 – that’s $380 in interest owed. After two years of not paying the bill, another 19% would be added onto that figure, leaving you with a bill of $2832 (the interest would have compounded and risen to $832), and the third year would see another 19% added onto that, leaving you reeling with a bill for $3370. After three years of neglecting, forgetting or refusing to pay your bills (which, like we said, we’re sure wouldn’t be the case with you sensible investors…) the amount of money you owe will have increased to eye-watering proportions.

So, what have we learned from all this? Compound interest can be a wonderful thing if you’re in the black. Slip into the red, however, and it’s somewhat less of an appealing system!