The Power of Compound Interest
What smart men say about compound interest
Let’s start with a few interesting quotes on compound interest.
Einstein: Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
Warren Buffet: My wealth has come from a combination of living in America, some lucky genes, and compound interest.
Charlie Munger: Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.
If these giants emphasize the importance of compound interest, it’s worth understanding its power. Right? Right.
Spoiler: many whom aspire financial independence consider compound interest the vehicle to make it happen. Its potential is enormous.
What is compound interest?
The principle of compound interest itself is easy to understand. It’s interest on interest. Or in other words achieved by reinvesting interest gains rather than paying it out.
As a result, interest in the next period is then earned on the principal plus previously accumulated interest.
A basic example, say a loan of €500.00 yields returns of 10% annually. At maturity €550.00 is repaid of which €500.00 is the principal amount and €50.00 is your earnings.
Rather than paying out interest, the gain of €50.00 is reinvested at 10%. At maturity your earnings have grown to €55.00. Rinse and repeat.
So what’s so special about compound interest?
Understanding the power of compound interest
The example in the previous paragraph explains what compound interest is, but this alone is not enough to understand its true power.
The power of compound interest lies in the exponential curve.
Let’s have a closer look at several scenarios in the below table using variable investment horizons and return on investment percentages.
The table assumes a € 1,000.00 investment.
Astounding isn’t it?
With a 1% return on investment you won’t even manage to double your investment after 30 years. Not investing your savings isn’t going to get you anywhere.
If you manage a return on investment of 4%, it’ll take roughly 18 years to double your investment. After 30 years your investment has turned into € 3,243.00.
Now let’s have a closer look at a 7% return on investment. Doubling your investment now takes rougly 11 years. A 30 year investment horizon will end up multiplying your initial investment over 7 times, resulting in a total of € 7,612.00.
Should you realize a 10% return, your investment will double in only 8 years. In 30 years time a mere € 1,000.00 has turned into € 17,449.00, multiplying the initial investment over 17 times.
And lastly, a 13% return will take 6 years to double your investment. After 30 years you’ll have € 39,116.00. Your initial investment have multiplied over 39 times!
Lots of numbers right? It’s time to put these in a graph to fully grasp the concept of compound interest.
The main variables to maximize returns
Okay, so now we’ve gone over the concept of compound interest and have seen its power. The quotes in the first paragraph are starting to make sense. So how do we get the most of of compound interest you ask?
Time: As you can see in the graph and table, the latter years are adding increasingly more value. Start investing early and reap the rewards of the latter years. Imagine if your investment horizon is even longer, say 40 or 50 years. Financial Independence is guaranteed.
Return on investment: The rate of return is a critical variable in order to get the most out of compound interest. Be very aware of the effect of fees and taxes. High fees and taxes eat into your returns exponentially as well! Obviously taxes are part of the equation, but based on where you’re located there might be options to reduce the tax burden and maximize your returns.
My personal investment strategy which relies heavily on these compound interest principles is crowdlending. Obviously the same principles apply to stocks, bonds and many other investment methods.