“Those who understand it, earn it; those who don’t, pay it”. So says the popular quote about compound interest. Read on to find out exactly what it is, how it works, and why it’s so important for investors.
What is compound interest?
Simple interest is generated purely on the amount of money that you invest. Compound interest is different.
Compound interest is essentially the interest that you can earn on your interest. It means that over time, the amount of interest you accrue on your investment will grow.
If you have an investment that pays yearly dividends, for example, both simple and compound interest would be the same in the first year. In the second year, however, compound interest would mean earning interest on both your initial investment amount as well as on the interest that you earned in year 1.
For those with a mathematical bent, the formula for calculating compound interest is [x(1+y)n – 1]-x (x is the original amount invested, y is the interest rate, n is the number of years you have held the investment).
This pattern continues with every year that you hold the investment, meaning that not only can your investment grow, the rate at which is can grow could increase too.
Some investments compound annually, others compound at different intervals, such as monthly, which can increase your investment’s value even more.
Who is compound interest investing right for?
Because of the way in which it works, compound interest is best for longer-term investments. The longer you leave your money in an investment product, the more years of interest will build up – and the more likely it is that you’ll see this snowball effect.
Those who invest for income – withdrawing some of their funds regularly to live on – will be drawing out the interest, which means that compound interest will not work properly.
Investing early in life means that compound interest could potentially snowball even more, which could be good for those looking to invest for retirement.
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