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Compound Interest

What is Compound Interest?

Compounding is the act of repeatedly adding interest to the balance it was earned on.

Thus the next time interest is calculated it is paid on the original amount plus interest already earned, so the rate of growth increases.

 

Some have said the most marvellous discovery ever made was that of compound interest, that is, an amount if left to grow time after time could grow exponentially (see picture). All it takes is some patience to get it going.

 

Exponential Growth

How Compound Interest Works

Let us use an example where you invest $1,000 in a lucrative investment that returns 5% every calendar month. At the end of the first month it returns $50 interest which is compounded to $1050. The next month the 5% is calculated on the $1050 to give $52.50, an extra $2.50 for just leaving last month’s interest there. The total is now $1,102.50. The next interest bill is $55.13 and so on;

 

Payment Intervals

Interest Payment Frequency Makes a Big Difference

The frequency of interest payments is also important. Note the two scenarios in the table above. The left sequence is for 60% interest per year but paid at 5% each month (5% times 12 months equals 60%). After 2 years 322% has been earned, against 256% interest if the interest was paid yearly. 

Regular Savings Boosts Investment Returns

Compounding can also be sped up further if a regular payment is also made. See the tables;

With Payment



The amount on the left green box is the return for the $1000 invested only, while the amount on the right green box is if a regular payment is also made each month. The blue box shows the total of the extra payments invested on top of the initial $1,000. Note the difference in the amount of interest (returned profit) each month.

Use Real World Interest Rates

Obviously 5% per month in this example is a high figure to help highlight the power of compounding interest. You can experiment with the spreadsheets using more realistic interest rates of up to 20% per year. See Spreadsheet One and Spreadsheet Two (Right-click and select Save Target As).

Further Reading

Compound Interest (wikipedia)