Jul 28, 2016 | Investment Advice

The power of Compound Interest!

What is Compound Interest?

When you invest over a period of time, compound interest is your best friend. In effect, it means you are earning interest not just on your own capital, but also on the interest you’ve already earned. Over the long term, this might be phrased as “interest on interest on interest on interest on interest …”

What’s the difference between Compound Interest and Simple Interest?

Compound Interest is interest paid on the initial principal (capital amount) as well as the earned interest on the money invested. This means you earn interest on the money you invest, and on the interest you have earned.

With simple interest, interest is simply paid at the end of the investment term on the initial invested money. You do not earn ‘interest on interest’ like compound interest.

How is Simple Interest and Compound Interest earned?

Imagine we place $100 in an investment that earns 10% pa. At the end of one year, we’ve earned $10. Imagine we spend all the interest we receive. At the end of each year, our investment amount is back to $100. That’s simple interest. At the end of 10 years, we’ll still have our $100, and we will have received a total of $100 in interest.

I = P(1+r)n-P

Don’t worry, we’ll do the maths for you, but this little formula contains a power that Albert Einstein is attributed to labelling “the most powerful force in the universe”. It calculates our net profit when we earn interest on the interest. That’s what compounding is all about.

Going back to our first example – if we re-invest the interest on our original $100, at the end of the first year we will have $110. Leaving it invested at 10% pa, we’ll earn interest of $11 in the second year, bringing the total in the account to $121. If we keep going for 10 years, our investment will grow to $270.70 – that’s our original $100 plus $170.70 in interest.

Time is money – literally

This example may not seem so impressive, but the power of compound interest really shines over the long term. Looking at our simple situation and taking the interest out each year for 30 years, we will earn a total of $300 in interest. But relying only on the compounding of the interest (ie. no other deposits are made), the total interest earned over the same time would be $1,883.74.

A child born today could easily live to 100. Simple interest on a $100 investment would amount to $1,000 over their lifetime. Left to compound untouched at 10%, that same investment would grow to $2,113,241! Even on such a small initial investment, that’s an incredible difference!

*Assumption on calculations: Interest is compounded monthly

Disclaimer: This information has been prepared by Primestock Securities Limited ABN 67 089 676 068, AFSL 239180 (“Prime”). Prime accepts no obligation to correct or update the information or opinions in it. This information does not take into account your objectives, financial situation or needs. Before acting on this information, you should consider whether it is appropriate to your situation. It is recommended that you obtain financial, legal and taxation advice before making any financial investment decision. Prime is bound by the Australian Privacy Principles for the handling of personal information.

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