Compound Interest – How to use the Effect Correctly

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Compound interest has a very big impact on capital accumulation. But what is it exactly and how is it different from simple interest? How do I make the best use of compound interest and how does it help me to increase my assets?

Basics

The term interest was first mentioned by the Sumerians, 2,400 years before Christ. The term compound interest also originated there. Since there was no banking system yet, interest was charged when money was lent. Over the centuries, the churches have banned, restricted and temporarily allowed the use of interest again.

The idea behind compound interest is this: you invest money and let it work for you. All earnings, profits, dividends, etc. are not paid out, but reinvested. The money thus works for you without you having to do anything for it.

Many already know the term, but cannot imagine how powerful this effect is. To illustrate the whole thing, here are some examples. In addition, I provide you with a compound interest calculator. Here you can simulate the development of your capital with different terms, savings rates and interest rates.

Example: simple interest

For example, if you invest $10,000 with an interest rate of 4%, then in one year you will have $10,000 + $400 interest = $10,400.

You then withdraw this $400€ and spend it and on clothes, something else or put it in your piggy bank. You are left with the initial $10,000. If you invest this $10.000 again to 4%, you will have again $400 over to spend, etc..

In 10 years from now you will still have the initial invested $10,000. Over the course of 10 years, you will also have received a total of 10 x $400 = $4,000 in interest. But what happens if you do not withdraw the $400 but reinvest it?

Example: compound interest

In the first year it works the same way as in the first example. If you invest $10,000 with an interest rate of 4%, you will receive $10,000 + $400 interest = $10,400 in one year.

But now you do not withdraw any more money, but leave the received interest on the account. After 2 years you will have $10,400 + 416€ interest = $10,816. We now also consider a period of 10 years again and you then have $10,000 x 1.04^10 = $14,802.

Now compare this with the other example.

simple interest: $10,000 + 10 x $400 = $14,000
compound interest: $10,000 x 1.04^10 = $14,802

The difference is in this example only $802. This does not seem to be that big. I meant earlier that this is a very powerful effect. How can you benefit even more from compound interest?

Illustration of compound interest

There are two factors that influence the effect. One is the length of the investment and the other is the amount of the interest rate. To better illustrate this, I have created two graphs. Here the effect of compound interest can be seen very well.

Compound interest effect at 4% interest over 50 years

1. Influence of the duration

In the previous examples, the effect was not yet really visible. But by extending the time period, it already looks quite different. Again, we consider two alternatives.

As in the example above, we again invest $10,000 with an interest rate of 4%. In the diagram, both alternatives are shown with a time period of up to 50 years. With an investment term of 10 years, the difference is only $802, with 25 years it is $6,658 and with 50 years it is even $41,067. We can therefore conclude that a longer term has a positive effect.

One of the richest person in our time has taken advantage of exactly this factor. Moreover, he has of course invested his money very well. It is Warren Buffet, who had a fortune of about 79 billion USD in 2020 (according to Forbes). You don’t see how big the number actually is until you write it out, and it’s something like USD 79,000,000,000. That’s a lot of zeros.

Warren Buffett also started small. At the age of 14, he had only USD 5,000, and by the time he was 21, he had USD 20,000. He had made his first million by the age of 30. It took another 25 years until Warren Buffett had his first billion on his account and then another 24 years to his current fortune at the age of 89. It took him 75 years to become so rich.

Compound interest at different interest rates over 45 years

2. Influence of the interest rate

In the diagram above, I want to illustrate the influence of the interest rate of the investment in addition to the influence of the time period. Here the difference is even more significant than in the previous example.

In the graph above you can see this time four different variants: 1%, 4%, 7% and 10% interest. As a duration I have chosen this time 45 years with an initial investment of $10,000. To clarify this, I have created the following table:

ariantCalculationDifferential amount
1% – Initial investment$15,648 – $10,000$5,648
4% – 1%$58,412 – $15,648$42,764
7% – 4%$210,024 – $58,412$151,612
10% – 7%$728,905 – $210,024$518,881

If we look at the chart and the table, we notice two things. Firstly, the effect is higher the higher the interest rate and secondly, it is noticeable that the difference increases as the interest rate increases. The difference between 4% and 1% is only $42,764, whereas between 10% and 7% interest it is $518,818. So it is not enough to invest the money only over a long period of time, but also at an high interest rate or yield.

So Warren Buffett could never have built up such a fortune if he had only achieved a yield of 1-2% per year. He only succeeded in doing this because he was able to achieve a yield of over 20% per year for years, first with Buffett Partnership and then later with Berkshire Hathaway. That’s how he became so rich and now he is able to donate a lot of money to charity.

Summary

So what can we learn from this article? I would like to summarize it and motivate you to start investing as early as possible. The compound interest effect is very powerful and can help us earn a lot of money. To do this, you need to do the following:

  1. Invest your money for the long term to benefit from the effect.
  2. It is best to start at an early age. If you invest $10,000 with 7% return rate at the age of 20, you will have $210,024 at the age of 65. If you invest $10,000 for your child at birth, your child will have $812,729 at the age of 65.
  3. The return on investment is crucial for the growth of your assets.
  4. Avoid investments with high fees.

If you would like to calculate this yourself, you can use our compound interest calculator.


Book recommendation

The Essays of Warren Buffett – Warren Buffett / Lawrence Cunningham

The Essays of Warren Buffett- Warren Buffett / Lawrence Cunningham

Warren Buffett’s essays have enjoyed cult status for more than two decades. Compiled and edited by one of the most renowned experts on value investing, Lawrence A. Cunningham, the letters from Warren Buffett to his shareholders summarized here are an unenlightened insight into the investment philosophy of the most successful investor of all time.

Much has been written about Buffett, but what does he himself have to say? The essays come from Buffett’s own pen. With sober wisdom, he talks about his investment decisions, how he selects his teams, and how he values companies.

The fourth, completely revised edition includes new, previously unpublished essays, including those on Berkshire Hathaway’s 50th anniversary (2015) and by Charlie Munger.


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