Effects Of Compounding Interest
Key Takeaways
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Compound interest is interest earned on top of interest
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The Rule of 72 helps you estimate how long it will take to double an investment at a given rate
What is compound interest?
Compound interest is interest earned on top of interest already earned. As you earn interest, it gets added to your principal amount, which together earns you more interest over time. If you start early, your investments will be able to compound over a longer time period. The earliest returns are reinvested for the longest time and therefore generate greater returns.
Example
Consider a $100 investment that earns 4% every year compounded.
|
Year |
Amount at the start of the year |
Interest earned in the year |
Amount at the end of the year (including interest earned) |
|---|---|---|---|
|
1 |
$100 |
4% x $100 = $4 |
$100 + $4 = $104 |
|
2 |
$104 |
4% x $104 = $4.16 |
$104 + $4.16 = $108.16 |
|
3 |
$108.16 |
4% x $108.16 = $4.33 |
$108.16 + $4.33 = $112.49 |
|
4 |
$112.49 |
4% x $112.49 = $4.50 |
$112.49 + $4.50 = $116.99 |
As you can see, the interest earned grows each year as the base amount grows, creating a snowball effect.
Note: Compound interest can also work against you when it comes to debt.
Rule of 72
Given a certain compound interest rate, how many years will it take to double my money? That's a question the Rule of 72 can help you solve easily.
When you divide 72 by the interest rate number, you will get the number of years required to double your money.
So if the interest rate is 4% p.a., 72/4 = 18 years. It will take 18 years to double the money under a 4% interest rate.
What does this mean for you?
Always pay your debt payments in full and on time before they compound. Start saving and investing early so your money has more time to grow.
