What is Compound Interest and Why Should You Love It?

If you’re a regular reader of the MoneySmart blog, you’ve probably come across the term “compound interest” more than once. We’re a huge fan of compound interest and often talk about it like it, instead of Brad Pitt, is God’s gift to mankind.

But we get that not everybody knows what compound interest is; after all, it’s not exactly something you learn along with the ABCs at kindergarten. Here’s why we love it so much.

 

You accumulate interest much faster than if it doesn’t compound

Many people make the mistake of thinking that if they receive, say, 5% interest on their investments per year, that means they can look forward to getting $5,000 per year for every $100,000 they invest.

However, in the above scenario, you would not be taking into account gains made from compounding interest. In reality, you would be earning significantly more than 5%.

That’s because each year, you earn interest not only on your principle sum of $100,000, but also on all the interest you’ve earned up to that point. That means in Year two, you would earn 5% of $105,000 and not $100,000.

If you think the interest you get each year won’t make a big difference even if it compounds, that’s where you’re wrong. Let’s see how much our friend with $100,000 would earn in 10 years.

Year 1: $100,000 + interest of $5,000 (100,000 x 5%) = $105,000

Year 2: $105,000 + interest of $5,250 (105,000 x 5%) = $110,250

Year 3: $110,250 + interest of $5,512,50 (110,250 x 5%) = $115,726.50

Year 4: $115,726.50 + interest of $5788.13 (115,726 x 5%) = $121,514.63

Year 5: $121,514.63 + interest of $6,075.73 (121,514.63 x 5%) = $127,590.36

Year 6: $127,590.36 + interest of $6,379.52 (127,590.36 x 5%) = $133,969.88

Year 7: $133,969.88 + interest of $6,698.49 (133,969.88 x 5%) = $140,668.48

Year 8: $140,669.48 + interest of $7,033.42 (140,669.48 x 5%) = $147,702.90

Year 9: $147,702.90 + interest of $7,385.14 (147,702.90 x 5%) = $155,088.05

Year 10: $155,088.05 + interest of $7,754.40 (155,088.05 x 5%) = $162,842.90

(Note that we rounded each sum up or down to two decimal places, so different ways of calculating the above might yield slightly different results.)

So at the end of 10 years, that $100,000 has generated an additional $62,842.90 thanks to a 5% compounding interest rate.

Conversely, if the interest had been simple interest rather than compound interest and you had simply earned 5% on $100,000 every year, only $50,000 ($5,000 x 5) would have been earned on the principal sum at the end of 10 years.

 

The earlier you start, the better

As you can see, with compounding interest, the longer you leave your money invested, the greater the rate at which your initial investment generates returns.

While our 10 year calculation saw us earning $62,842.90 with our initial sum of $100,000, we used a compound interest calculator to figure out how much we’d have if we left that same sum invested at the same rate of 5% for 20 years instead.

And the answer is, we’d end up with $265,329.77 in total… that’s an increase of $165,329.77, which is pretty mind blowing.

In years 1 to 10, our initial sum earned us $62,842.90 worth of interest. From years 11 to 20, the same initial sum plus the interest from before netted us $102,486.87!

This is great news for those who are young and don’t have that much to invest. Just having 5 to 10 years’ head start on your peers means that your money can grow way more than theirs can. That means you won’t have to start with as large a principal sum as someone who starts investing much later.

So the next time someone complains they have no money to invest, tell them they have time—and sometimes, time is the only thing you need.

Have you ever made fantastic gains thanks to compound interest? Tell us in the comments!