Compound interest simply explained

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Who does not dream of increasing or even multiplying their money in their sleep? This dream has long been a reality for well-rested investors. The reason for this is a largely underestimated financial phenomenon: compound interest.

Compound interest was the greatest invention of human thought. Albert Einstein (allegedly)

What is compound interest?

The compound interest describes the interest that investors receive on interest. If interest amounts are reinvested or reinvested immediately, there is a compound interest effect: the invested capital grows faster, as interest paid out immediately earns interest again.

Compound interest is an easy way of building wealth . However, due to its simplicity, it is often underestimated. In general, however, you should definitely use the compound interest effect to increase your money .

The principle is simple: you usually receive interest on invested capital, which is credited to the investment. If the interest is not issued and remains in the investment, it will earn interest in the following interest period together with the original capital. This increases the interest-bearing capital and accordingly you receive more interest income than in the previous interest period. This means that wealth grows faster and faster.

Sample calculation

If € 3,000 is invested at 7.0% interest pa, the initial capital will have more than doubled after around 11 years . After 15 years it has almost tripled.

yearSeed capitalinterestFinal capital
1€ 3,000210 €€ 3,210
2€ 3,210€ 225€ 3,435
3€ 3,435€ 240€ 3,675
4th€ 3,675€ 257€ 3,932
5€ 3,932€ 275€ 4,208
10€ 5,515386 €€ 5,901
11€ 5,901€ 431€ 6,314
15th€ 7,736€ 541€ 8,277
20th€ 10,849€ 759€ 11,609

For comparison

If € 3,000 is invested on the same terms without compound interest, the capital will only have grown to just over € 6,000 after 15 years .

yearSeed capitalinterestFinal capital
1€ 3,000210 €€ 3,210
2€ 3,000210 €€ 3,420
3€ 3,000210 €€ 3,630
4th€ 3,000210 €€ 3,840
5€ 3,000210 €€ 4,050
10€ 3,000210 €€ 5,100
15th€ 3,000210 €€ 6,150
20th€ 3,000210 €€ 7,200

Short interest periods increase the compound interest effect

In the previous example, an annual interest rate was assumed. In the case of interest payments during the year, however , the interest is not paid once a year as usual, but every six months, quarterly or monthly. The fact that interest or compound interest is taken into account more often in the current interest rate means that profit increases even faster.

Mooring: When? How much? How long?

  • The sooner the better.
  • The more the better.
  • The longer the better.

Ideally, a larger amount is either invested early or smaller amounts are invested regularly (for example as part of a savings plan ). You should also let your money work for you as long as possible. Because the compound interest effect takes a long time to develop its full potential.

What is the compound interest formula?

The compound interest formula can be used to calculate how much final capital is available after a certain point in time by adding interest to the capital.

n  = K 0  x (1 + (p100)) n
n  – final capital
o  – initial capital
p – interest rate
n – running time

If we take € 3,000 again and put this on at an interest rate of 7.0% for 5 years, the result is the following interest calculation:

5  =  € 3,000  x (1 + (7.0100)) 5  = € 4,208

After 5 years, the assets have grown to € 4,208. That means an increase in assets of € 1,208. Without the renewed interest on the income, it would only be € 1,050 (€ 210 per year). The compound interest effect alone brings in an additional € 158 in this example .

Which forms of investment are suitable?

The compound interest effect is considerable, especially in connection with high interest rates . In the best case scenario, you should therefore stay away from low interest rates.

It is precisely low-risk investment options such as overnight money, fixed-term deposits or savings accounts that bring investors only low interest. High-return investment opportunities are usually associated with an increased risk. Therefore it is always recommended capital across different asset classes and maturities to spread .

Stocks are the classic among high-yield investments. However, due to their fluctuations in value, they should only be consumed with caution. Equity funds, on the other hand, offer the opportunity to diversify your portfolio. But alternative investment options such as crowd investing or crowdfunding also attract with sometimes very high interest rates and can even score points with savings plans.

Investment tips

  • If you choose (if possible) an investment option with annual or intra-year interest rather than bullet interest, the interest can be reinvested more often and therefore reappear earlier.
  • In the best case scenario, steer clear of low interest rates.
  • The higher the risk, the higher the interest rate – spread the risk through diversified portfolios.
  • Choose (if possible) an investment without incurring fees and thus keep the costs low.
  • In any case, leave the interest in the investment; your money will work by itself.