Compounding interest (or compound interest) is the most important concept in investing. Although acquiring a deep knowledge of investing would entail grasping hundreds of different financial concepts, a functional understanding of compound interest is the one thing that no investor can ever do without.
This post is designed to illustrate the following aspects of this all-important concept:
- What compound interest is and how it differs from simple interest
- The enormous benefits of allowing your investments to accrue compound interest for long periods of time
- How compound interest works against you in long-term debt scenarios
The Difference Between Simple and Compound Interest
Put briefly, simple interest is interest that's computed only on the principal, which is the original amount invested or loaned. You can compute simple interest by multiplying the principal by the interest rate and a given period of the loan or investment. Here's an example of simple interest taken from Investopedia.
If you borrow $10,000 at 5% interest for three years, you would multiply these figures to arrive at a total of $1,500. Thus the total repayment cost of the loan would be $11,500.
Compound interest is interest that is computed on both the principal (the original amount of the investment or loan) AND the interest accrued during the previous periods. In other words, compound interest is "interest on interest." The formula for calculating compound interest is this:
A = P (1 + r/n) (nt)
Unpacking this formula is beyond our scope, but by using an online compound interest calculator, we can see that $10,000 invested for three years at 5% compound interest will yield a total of $1,576.25.
This means that your total investment after three years will be worth $11,576.25, which is $76.25 higher than you would have earned with simple interest. This represents an increase of approximately 5% compared to what you'd accrue with simple interest.
The Benefits of Compound Interest Over the Long Term
There is incredible power in compound interest that you can unleash by investing a reasonable amount for about 40 years, as a retirement fund for instance. Let's show an example of how powerful compound interest can be when you invest over the long term. (For related reading, see: The Effect of Compounding.)
Let's say that a 25-year-old person invests $10,000 in the stock market and earns an annual compound interest rate of 5%. Our online calculator informs us that the total value of this investment after 40 years would be $73,584.17. If you examine this calculation more closely, you'll see the enormous benefit of long-term investing.
Here are the total values of this same investment from years 20-40 in five-year increments.
This data speaks for itself. The total value would more than double over the last 15 years, and almost triples over the second 20 years. Another way to look at it is you gain roughly $17,000 in the first 20 years on your investments while earning over $46,000 in the second 20 years. Hopefully, the moral of this story is abundantly clear—start saving early for maximum results and be patient as the big gains come later on. Just look at the likes of Warren Buffet, arguably one of the best examples of how the power of compound interest works. He credits his fortune with exercising this basic principal and still preaches it today. (For related reading, see: Why Save for Retirement in Your 20s.)
The Downside of Compound Interest Is Reserved for the Borrower
But there's a significant downside to compound interest as well, at least when it's accruing on a debt that you owe. Just as financial institutions pay you compound interest for the temporary use of your money, lenders also charge you an often very costly rate for the usage of their funds.
It's just as important to understand this negative aspect of compound interest as it is to be aware of its benefits. A little reflection will make the lesson of all this quite clear—invest for the long term, but be very aware of how carrying debt, such as credit card balances that have rates as high as 20%, can really destroy wealth. As simple as this sounds, it remains one of the essential keys to sound investing and economic security.
(For more from this author, see: How to Start Investing With Just $100.)
To learn more about working with a financial advisor, you can download the free guide, The Ultimate Guide for Choosing Financial Advice.