Albert Einstein said that compound interest is the most potent force in the universe, aware that thanks to compound interest even with a small capital to invest if you get an excellent return, especially by patiently exploiting the lever of time.
What is compound interest?
Compound interest is a method that, over the years, makes an investor’s wealth grow exponentially. It has exponential development.
Compound interest, combined with a prudent long-term investment, is the secret to accumulating large fortunes. Thanks to the composition of interests, it is possible to achieve relative simplicity – and relatively controlled risks – relevant financial objectives, as long as you have the proper patience.
How does compound interest work?
Imagine investing $ 20,000 and earning 10% net interest in one year. This means that at the end of the period, you will have generated a capital gain of $ 2,000. Instead of pocketing these interests, you decide to reinvest them. Imagine that for the second year your investment again generates 10% interest. Return is now calculated on a $ 22,000 basis. This means that your investment will return you $ 2,200, $ 200 more than it would have produced if you hadn’t reinvested the interest.
Now, a $ 200 difference isn’t particularly significant (considering a 10% return is also relatively high). But let’s see what would happen by experimenting. In the third year, your interest would be calculated based on $ 24,200, generating a return of $ 2,420 (instead of the usual $ 2,000 you would have generated if you had not decided to invest the interest). With the same returns, the extra income that you would have obtained thanks to the reinvestment of interest tends to grow over time, becoming an increasingly large slice of your investment. Precisely this is compound interest, an effect that favors investors who decide to remain invested for a long time while also using the returns obtained.
Time is the investor’s best friend: starting to invest early, with long horizons, allows you to position yourself in the best way to generate returns.
Simple interest and compound interest, differences
Simple interest is calculated on the initial capital for each period taken into consideration. For each period (C) the interest is calculated by multiplying the initial principal (C) by the interest accrued for each period. The riser always remains the same and constant.
On the other hand, in compound interest, the interests in the first period (t1) are capitalized, calculating the amount of capital on which the interest will be calculated during the following period (t2).
How do we calculate compound interest?
The difference explained in the previous paragraph affects the compound interest calculation formula. Regarding simple interest, the result of an investment (M) is calculated in the following way in the case of constant interest:
M = C x (1 + r x t)
The amount is equal to the principal, multiplied by the interest (1 +3) for the investment periods. On the contrary, the compound interest formula must take into account the effect of the capitalization of interest, and therefore it is calculated as follows:
M = C x (1 + r) ^ t
How should the investor behave?
Understanding compound interest brings with it a few important lessons for the investor:
- The earlier you start generating interest, the better the likely long-term result of the investment will be.
- Reinvesting what has been obtained thanks to your investment is a choice that can have a huge impact on the result of the investment.
- With the same return, extending the investment duration can have exponential effects on the final result.
Always choose to be accompanied by an expert consultant, choose it carefully, because it will have to follow you for many years: the assumption of compound interest is a prudent investment. So it is vital to have a consultant who accompanies you, avoids scams, defines your financial plan modeled on your goals, and adjust it every time these will change in the course of your life. Knowing that you have him next to you will make your life better.