Tuesday, 21st June 2011

Compound interest

Written by George Traganidas Topics: Personal Finance, Wealth Building

Compound interest is when the interest you have earned earns interest itself. For example, if you deposit £1000 in the bank and you get 10% interest per year, at the end of year 1 you will have £1100. Then at the end of year 2, you will have £1210. During the second year the interest is applied to your original amount (£1000) and to the interest that you gained at the 1st year (£10). This is how money multiplies over the years and it works for you. Notice that you have only deposited £1000, but then the money that you gain from interest multiplies by itself (together with your original amount) and works for you. This is the secret of how to become rich. Many of the richest people in the world have used this simple idea to create their fortunes, e.g. Warren Buffet, John D. Rockefeller.

If you look at the tables below you will see some examples on how compounding works. Compound interest depends on 3 factors:

  • The initial amount you deposit.
  • The rate of compounding.
  • The frequency of compounding.

Compound Interest Examples

In example A that I use as a basis, you see the effect of compounding for an initial amount of £100, given a return of 10% for 20 years. At the end you will have £673. Compare this with example B where the rate of compounding is doubled. At the end you will have £3834. This return is about 5 times more. In example C, the time period is doubled; the final amount is £4526 and that is about 6 times more. The same effect you can achieve if the interest is applied more frequently than once a year. In example D, we double the initial investment to £200 and the final amount is £1345. This is about 2 times the original investment.

From the above examples you can see that the increase in the time of compounding has the biggest effect on the return. The second best return you achieve by increasing the rate of compounding and the least one is by putting a bigger initial investment. By this, I hope you can see the mistake that many people make when they are saving for their old age. They do not start saving early enough and they lose on the biggest accelerator of wealth. When they realise this, they try to make up by increasing the amount they invest, but as we have seen this has the least effect.

It is not always easy to achieve a higher rate of compounding without increasing the chances of permanent loss of capital and thus you need to take care when you try to achieve a better rate.

Compound Interest Graph

As you can see from the graph, if you plot the returns from compounding and the time it takes to achieve these returns you will get an exponential graph. This shows the power of compounding. The start is slow and boring. This is where most people get discouraged and they give up because not much is happening and they do not believe in magic. Once you pass a certain threshold though, the magic begins. The gains are becoming larger and larger and the power of compounding kicks in. As with any exponential graph after a certain point the growth is mind blowing.

Only investors who have patience can get these returns and enjoy them.

Follow the practical way,

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1 Comment to Compound interest

Osanubi Goodluck.
16 December 2016

This is one of the most amazing peice I have read in my whole life. Well done Mr Traganidas George.

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