Understanding Compound Interest: Calculation and Benefits

One of the most important concepts for our finances is undoubtedly that of compound interest. This simple but powerful tool quickly takes us into the future, away from the short-term noise we often experience in financial markets. Indeed, compound interest or “interest on interest” allows us to obtain compound returns over time, multiplying our money without extra effort.

Sounds good, right? Compound interest is one of those concepts that always hovers over the head of any investor but is sometimes forgotten because it requires an abundance of one key element: time.

compund interest formula

What is compound interest?

Compound interest is the interest that accumulates on both the initial capital invested (principal) and the interest accumulated and reinvested during previous periods.

Compound interest is a key term in finance and is usually the cornerstone on which some long-term investment strategies are based.

Characteristics of compound interest

The idea behind compound interest is based on two elements. On the one hand, the passage of time and, on the other hand, the accumulation of interest. Unlike simple interest, compound interest is distinguished by:

  • The interest is added to the initial capital
  • The return is applied to an increasingly larger capital as a result of the sum of interests
  • Time is essentially what will allow you to grow your capital. Money creates money.

Why compound interest benefits you

There is a huge difference between adding interest to the initial capital and withdrawing the interest for personal expenses. The added interest grows your capital exponentially over time with no effort or extra savings.

The longer the term in which the capital plus interest is accumulating and earning more returns, the more money you accumulate.

Many believe that to make money investing means to achieve a high annual return or to beat the market. But in reality, in the long term, the most important thing is not the rate of return obtained but time and patience. Compound interest allows you to build wealth even if you start with low capital.

Warren Buffett's fortune and compound interest

Warren Buffett is a famous example of the power of compound interest. Although he started investing at 11 years old, he stated that he regretted not starting earlier, as with each passing year, the impact of compound interest becomes more powerful.

Warren Buffett is currently the fifth-richest person in the world according to Forbes, achieving a return of 20% per year (a very high return. Obviously, it is worth noting that it has not been easy as Warren himself went through sharp declines throughout his life.

Allowing compound interest to work overtime is not as easy as it seems. The market goes through cycles, both bearish and bullish, and sometimes you may even have to see your investment decrease by 60% before it starts a new bullish cycle.

Below, you can see Warren Buffett's portfolio's performance over the years. His wealth continues to generate more and more wealth over the years, even if there are some temporary decreases.

warren buffett net worth

Compound interest calculator | Formula and elements

How to do compound interest?

The compound interest formula is based on time and the reinvestment of interest. Therefore, the formula to calculate compound interest is:

compund interest calculator

The elements for the calculation of the compound interest formula are as follows:

  • Initial capital (principal)
  • The rate of interest or the annual return
  • The period of time we keep the investment

Example of compound interest application

Here is an example:


For an investment of £50,000 over 30 years with a 10% annual return:

  1. Compound interest: The total amount would be approximately £872,470.11.
  2. Simple interest: The total amount would be £200,000.

This shows how much of a difference compound interest makes over time, compared to withdrawing the interest each year.

Where to invest to take advantage of compound interest? | Accumulation funds

So, when investing, there should be a consistent rate of return; over time, the money grows thanks to compound interest.

As we generate interest and reinvest it, we will gradually see how “the magic of compound interest” begins to act, not only making our money grow like a snowball that gains size almost effortlessly, but also protecting us from future market downturns.

Once we have overcome the barrier of the first 5–7 years, where the value of our portfolio will still be very much linked to the initial contributions, the interest we obtain will represent an increasingly larger cushion to withstand the fluctuations of the markets.

To maximise the effects of compound interest, we must always think long term while minimising costs. One way to do this is Index funds.

Also, accumulating funds are key – they automatically reinvest your payments (such as dividends or interest). Check out our accumulating vs distributing ETF to find out the differences between the two types of funds.

Here are some examples of accumulating funds you could invest in:

Fund NameCategory3-year Return5-year Return
Morgan Stanley Investment Funds – US Growth FundUS Equity13, 67%50%
Baillie Gifford Worldwide Long Term Global Growth Fund Class B EUR AccUS, EU, Emerging Equity80%131%
Franklin Gold & Precious Metals Fund NGold and Metals Equity17%41%
Allianz Global Investors Fund – Allianz Global Artificial Intelligence RT H2-EURTechnology Equity72%
JPMorgan Funds – Asia Growth Fund A (Acc) – USDAsia Equity12, 25%20,56%
BlackRock Global Funds – World Gold Fund A2 EUR AccGold and Metals RV-5,61%%12, 19%
T. Rowe Price Funds SICAV – Global Technology Equity Fund I USDTechnology RV28,80%51,65%

Learn more about passive investment

Summary

Overall, compound interest is a key concept if you are interested in generating wealth passively. Although time is crucial, it could be a way to build a secure financial future without necessarily starting with lots of funds. Instead, patience is key as you let your principal grow with each interest or dividend payment.

FAQs

How does compound interest differ from simple interest?

Unlike simple interest, which is calculated only on the principal amount, compound interest is calculated on the principal amount and also on the interest that has been accumulated over previous periods.

Why is compound interest important for savings and investments?

Compound interest can significantly increase the value of savings and investments over time, as the interest earns interest, leading to exponential growth.

Does the rate at which interest is compounded affect the final amount?

Yes, the more frequently interest is compounded, the higher the total amount will be. For example, £1,000 invested at a 5% annual rate will grow more if compounded monthly rather than annually.

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