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  • Compound interest, how do you profit? – THIS IS WHAT YOU NEED TO KNOW!
  • Compound interest, how do you profit? – THIS IS WHAT YOU NEED TO KNOW!

Compound interest, how do you profit? – THIS IS WHAT YOU NEED TO KNOW!

Compound interest, what is it?

The brilliant German scientist Albert Einstein called the compound interest effect the eighth wonder of the world about 100 years ago. To this day, it is a beneficial effect that occurs with many investors. Incidentally, this phenomenon is known by several names and terms. The most commonly used are: compound interest, compound interest, compound interest and compound interest.

But what is compound interest? It is actually very simple. It occurs when interest is calculated on your starting capital. This interest is credited to your starting capital. In a subsequent term, interest is again calculated, only this time on both the starting capital and the previously earned interest. In this way, you always get a higher return.

Compound interest should be distinguished from traditional simple interest. Simple interest is only calculated on your starting capital and not on your accrued interest. Well, it should be said, in practice compound interest is (much) more common than simple interest.

There are a number of factors that affect compound interest. These are as follows:

  • Interest rate: the higher the interest, the higher the amount on which interest will be calculated each time.
  • The frequency of interest payments: the more often interest is paid, the higher the amount on which the next interest is calculated. This means that you build up more (and faster) in the long term. Fixed intervals are often used. Think of years, quarters, months or days.
  • The time factor: The longer your investment horizon, the more time you have to benefit from the advantage of compound interest.

Calculating Compound Interest

Calculating compound interest is not very difficult. You can simply fill in the following formula:

A = P(1+r/n)nt

In this formula, ‘A’ stands for the future value. ‘P’ stands for the initial capital, ‘r’ stands for the interest rate and ‘n’ stands for the number of interest periods. Finally, ‘t’ stands for the time (for example in years).

Calculation example:  suppose you deposit a one-off amount of €5,000 euros into a savings account. You receive 7% interest on this annually, this interest is calculated annually. In 15 years you will have a total amount of €13,795 euros, without having to do anything.

Compound interest on your investments works in principle exactly the same. For example, if you have invested in  ETFs  and you expect to achieve a (fictitious) annual return of 7%, you can use the same formula to calculate your final capital.

The Rule of 72

Another useful principle that you can use in practice is the rule of 72. With this rule you can estimate exactly how much time you need to double your investment. In addition, it illustrates the working of compound interest in another way. The formula is as follows:

72/r=Y

In this formula, ‘r’ is the compound interest (per year) and ‘Y’ is the number of years it will take until the amount has doubled. The only number you need to fill in is ‘r’. After all, ‘Y’ is the result.

Calculation example: suppose you again use a fictitious return of 7% per year. 72/7= 10.28 years until your investment has doubled.

It is important to be aware that this is only an indication and does not always provide a guarantee when  investing  . Due to continuously changing social and economic circumstances, it is never possible to provide a watertight formula. 

The Pros and Cons of Compound Interest

Above we briefly discussed that compound interest can be very beneficial in practice. By adding money every month or by simply leaving your money in an (investment) account, your wealth grows exponentially while you do little. You could see it as  an automatic form of investing .

However, you should also be aware of the disadvantages. These disadvantages mainly occur with loans (often with credit cards). There are enough credit providers and credit card companies that charge interest on the loan and the interest. It often happens that people have a higher debt than the amount of money that has been borrowed.

Know the risks

Even though compound interest can be beneficial for you, you should always be aware of the risks associated with investing. It is possible that you will lose part or all of your investment within a short period of time. This should be emphasized even more for novice investors. It is therefore advisable to always spread your risks well and to absolutely not invest with money that you cannot afford to lose. Before you start investing, it is wise to draw up a well-thought-out strategy. Choosing a suitable broker can also have an effect here.  So make sure that you compare brokers  and choose the broker that best suits your strategy.

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