What is compound interest and why is it so important?
What is compound interest?
Compound just means something that comes in two parts. Interest is the addition of a small amount of money at the end of the year to the money that you had at the start of the year.
Compound interest refers to the additions of a small amount of interest on the interest that you earned in earlier years. In other words, the addition of a small amount of money to the small amount of money you earned the year before.
Why is it so important?
The table below shows what happens to $100 over 1, 5, 10 and 30 years at different interest rates. If we started with $100 and held it for 30 years at 2.0% interest, you would expect $60 of interest, so you’d end up with $160 at the end of the 30 years. But my table shows $181. Where does the extra $21 comes from? The extra $21 comes from the 2% interest that you’d earn on the interest that was earned in the year before, ie. The compound interest. Taken over time, the 2% extra you earn on the 2% interest, taken over 30 years adds up to $21, or 21% of your starting sum!
This effect becomes far more powerful once the interest rate or growth rate becomes higher. At 5.0%, $100 becomes $432 after 30 years. Once we start considering stock investing type returns at the 10 % to 12% levels, compounding leads to $259 and $311 after 10 years, and the large sum of $1745 and $2996 after 30 years.
Conclusion: compounding is a powerful effect.
Effect based on $100
| Growth Rate | 2.0% | 5.0% | 10.0% | 12.0% |
|---|---|---|---|---|
| Years | ||||
| 1 | 102 | 105 | 110 | 112 |
| 5 | 110 | 128 | 161 | 176 |
| 10 | 122 | 163 | 259 | 311 |
| 30 | 181 | 432 | 1,745 | 2,996 |