If you are looking for a powerful option to gain maximum returns on your investment, you may think of compound interest. In the world of investment, compounding is considered to be a miracle that can grow your money and no other option can match it.
If during your school days, you were finding it difficult to solve sums on simple and compound interests, you may be surprised to know that the math is incredibly simple. The power of compound interest has been appreciated even by Albert Einstein who called it the greatest invention of all time in mathematics and further added that people who understand the concept can earn it, while those who don’t will end up paying it.
Understanding Compounding
You have to understand the basic three variables of inputs that are obviously the most important when it’s about calculating your returns.
Although great mathematicians and overall financial community praised it, interest on loans was by and large tabooed by most of the largest cultures and religions in the world. Known as usury, i.e. the act of lending money at interest or excessive interest, the notion of interest (so, by definition simple and compound interest) survived the test of time.
Today’s scenario is that compound interest and financial investments can barely be separated and is typically used as one of the most commonly used metrics in the field of investing. It should be remembered that while compounding can amplify the returns on an investment, it can even equally amplify the liabilities when you borrow money based on compound interest.
The Eighth Wonder of the World
If you want to understand compound interest, you first should understand simple interest and only then you can realize the power of compound interest. So, what is simple interest after all?
Simple interest is defined as a percentage (or interest) gained on your investment that is paid to you after a stipulated time period, normally one year.
On the other hand, compound interest reinvests the interest gained at the end of every year or whatever may be the decided period and adds to your capital which again adds to the interest you receive the following year.
Let’s take an example.
Suppose you invested $1000 into a fixed deposit for one year with a yearly interest rate of 5%. Thus, at the end of the year, you will get $1050 where $50 is the interest you earned.
Now, let’s consider the same option but this time suppose you opted for a 2 year fixed deposit, then there are two ways with which you can make money.
The first option allows you to invest $1000 at 5% yearly interest rate. Thus, after the first year, you will earn $50 on your investment. Again you invest the capital of $1000 and after the second year too, you earn $50. Thus with simple interest, you made a total profit of $100 in the 2-year period.
Now, we’ll take the same example but in the context of compound interest and let’s see what difference it makes.
After one year, you earn $50 interest. But rather than withdrawing it, you reinvest it again for the second year together with your starting investment of $1000.
Thus for the second year, you’ve invested $1050. So, at the interest rate of 5%, your investment would become $1102.5. Here your initial investment was $1000 and you earned a profit of $102.5.
If you compare the simple and compound interest, it’s clear that with compounding you earned an additional $2.50. As the years pass, with the same yearly interest rate, but with compound interest, you can expect that your returns will also increase considerably as against simple interest.
What is Compounding?
Compounding is nothing but a process of gaining more returns on an investment by re-investing the earning on the investment. This means that compound interest is earned when the interest that is accumulated starts accumulating interest on itself.
To some people, it may seem quite complicated, but actually, it’s a very easy-to-understand concept. There is a requirement of three important things if you want compound interest to work for you. These are the reinvestment of the earnings, period of time and the rate of return.
Mathematically speaking, the compounded return or compound interest is the rate of return stated in the form of a percentage. It reflects the cumulative effect of a series of profits or losses on the initial investment amount over a certain period of time.
Here’s the formula of compound interest:
Yearly compound interest = the future value of the investment in addition to interest
Advantages of Compounding in Finance and Investing
Rates of interest have a major role to play in any kind of investment. In any case, the rate of interest set by the central bank becomes the benchmark simply for anything, from debt to investment. Hence it can be assumed that interest rates are at the centre of investing. The accrual of investing is an important concern, both for investors and lenders. Interest plays a dual role since it’s advantageous to one’s investment but consecutively it can also end up consuming the other’s investments.
In particular sorts of investments like dividends and bonds, compounding can play a huge role. If done appropriately, these types of investments can help the investor to soon increase their investments through the power of compounding.
Thus, if you invest $10,000 in a stock paying a dividend at an average yearly return of 12% including both the dividend payments and appreciation of stock price, you can earn $96,462 after 20 years. And if you invest the same amount in a stock that doesn’t pay a dividend with the same yearly return, it would give a total income of $56,044 i.e. around half the amount earned with a dividend paying stock.
The concept of surfing
Apart from dividends, bank deposits such as fixed-term deposit or savings account and also certificates of deposits are classic examples of compounding returns.
Investors that hold bonds can reinvest their yearly or bi-yearly interest earnings on buying other bonds or investing that amount in other types of investments. Note that some particular kinds of bonds such as zero coupon bonds automatically include compounded returns.
All in all, if you haven’t yet considered compounded returns of investment, consider it and you’ll realize how beneficial they can be. Happy investing!