investing

What is Compound Interest, and Why is It So Powerful?

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Compound interest can have a noticeable impact on your ability to accumulate wealth. It's an effective way to let your money make money.

It's even said that Einstein referred to compound interest as the "8th Wonder of the World". Whether that's true or not, the power of compound interest is evident.

 

What is Compound Interest

First, the formal definition:

This can be demonstrated by an example. Imagine that you have $10,000 and you are considering two different investment options. One of the options offers 5% simple interest per year, and the other offers 5% compound interest per year.

For the simple interest option, you simply earn 5% of $10,000 each year. That means that in this example, each year you would get $500 of interest.

For the compound interest option, you would earn 5% of your total account balance each year. In the first year, you would earn 5% of $10,000, just like the simple interest example.

But after the first year, your account balance would be $10,500, and you would earn 5% of that ($525). Then after the second year, your account balance would be $11,025, and you would earn 5% on that in the following year ($551.25).

The example shows that if all other things are equal, compound interest offers a bigger reward than simple interest. The reason is that you would be earning interest on a growing balance instead of a fixed balance.

 

The Power of Compound Interest

Let's look at some examples to see just how powerful compound interest is.

From our example above, if you earned 5% simple interest per year on an initial balance of $10,000, it would take 20 years to double your money and see your account balance reach $20,000.

If, on the other hand, you earned 5% compound interest per year on that same initial balance, it would take just over 14 years to double your money. The simple interest option takes more than 40% longer to reach the same $20,000 account balance.

It's worth noting that the higher the rate of return, the more powerful the effect of compound interest. Let's look at an extreme case that's helpful for illustrating just how powerful compound interest can be.

Imagine somebody came to you and offered you two options. They said you can either be given a gift of $10,000, or you can be given a magic penny that doubles in value every day for a month. Which would you choose?

For many, at first thought, the $10,000 sounds noticeably more significant than the penny, so they might choose the $10,000.

But let's do the math and see just how valuable that penny becomes. Here is how the value of the account looks for the penny example:

What you can see is that little penny turned into more than $5 million by Day 30 with the power of compound interest. The main factors that amplified its performance were the interest rate (100% in this example) and the speed at which it compounded (every day).

These examples show how impactful it is to invest in vehicles that offer compound interest. It's important to note that you have to leave any interest earned in the account to benefit from the power of compound interest.

 

Principles of Compound Interest Applied to the Stock Market

You could of course invest in standard interest-bearing accounts, but you could also use this same compounding principle in the stock market.

The idea is that if you buy a stock, and then price goes up and you sell it, then you invest the added profit in your next stock purchase.

As long as your making money on your stock purchases overall, then this will compound the growth of your trading account.

 

Conclusion

When considering the old saying that "the rich get richer", you can see how that might indeed be possible given the power of compound interest. If you have money, then compound interest can be an effective way for your money to make money.