How Compound Interest Works

Compound interest is one of the most powerful ways of growing your wealth because of the exponential nature of it's returns. In this short post, I'll explain the difference between simple and compound interest, and teach you a simple calculation for projecting returns!

Simple Interest vs Compound Interest

Simple interest is calculated on the original sum of money. For example, if you invest $10,000 in a 1 year CD at the bank earning 1% interest, your return at the end of the year would be $100 ($10,000 x 1.01).

With compound interest, the returns are added to the principal every period (e.g. monthly, quarterly, annually) and the next period's return are calculated on the total principal. For example, if you invest $10,000 in a 5 year CD earning 1% interest, your return at the end of 5 years would be $588.37 ((1.0115 ^ 5) x $10,000). You'll notice that the return here is more than just $100 x 5. That is because the interest you earned each year was added to the principal, and the next year's return was based on the total. It compounded.

Most investments compound. Simple interest is typically only used to calculate loans. So it's not something you need to scrutinize when planning your investments, but the concept is powerful when you understand what's possible at higher rates of return!

Take a look at the chart below:

Notice how big of a difference in result there is between each return over a 10 year period! The higher the percentage, the more exponentially your investment will grow, with each additional percentage making a huge difference. This is why it is so important to work with the best investment managers and use low-cost investments. Even 1% makes a big difference over time.

It's also why you should invest as much as possible. The long-term benefit of investing is tremendous because your money is working for you and you don't have to work!

You can play with the spreadsheet here: Spreadsheet

Compound Interest Calculation

To calculate compound returns on your calculator, just switch to the scientific mode and follow this process: Convert the return to a decimal and add 1.00, use the exponent function on your scientific calculator (Xy) and multiply by the number of years/periods, then multiple by your initial investment.

For example, a $100,000 investment compounding annually at 8% for 10 years would be calculated as follows: (1.08 Xy 10 = 2.1589) x 100,000 = $215,890. Cool, right?!

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