I don’t understand it like at all. I’ve heard it’s beneficial moneywise but I don’t understand why or how to invest in compounds??
Reading online it seems that it’s beneficial however that’s all I seem to understand so if it is something to look into and invest in I’d like to Understand it better 🙂
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The longer you invest the faster your investment grows.
10% interest on $100 doesn’t give you +$10 per year because compound interest keeps applying.
Year 1 turns $100 to $110 (+10)
Year 2 turns $110 to $121 (+11)
Year 3 turns $121 to $133.1 (+12.1)
Even though you haven’t put any more money in than the initial $100
Compound interest really just means that when you get interest, it’s added to your account as if it was money you always had. Then the next time they calculate how much interest you should have, the interest from the last round is included and you should get a little bit more money than last time.
Like, if you have $1000 in a bank account and get 1% interest, that’s $10 added. So now you have $1010 in the account. Next round of interest is calculated on that and you get $10.10 in interest, slightly more.
The “non-compound” way would just keep giving you $10 each interest cycle instead.
Is it worth it? Ultimately, yes, but as you can see from my numerical example, after 2 years, you’re only up 10 cents. Yay, more money, but the improvement isn’t as substantial as some people think it is. My example only paid out once a year to make the math easy, and monthly interest calculations will benefit you better, but it’s still not the magic bullet people wish it were. Unless you can get a really nice interest rate.
You have $1 in the bank that makes 5% per month. At the end of the 1st month, you now have $1.05.
Month 2: $1.05 + 5% = $1.10
Month 3: $1.10 + 5% = $1.16
Month 4: $1.16 + 5% = $1.22
Each month, you are making interest on interest you previously earned, which is called compounding interest.
I think the better way to think about it is to compare it to it’s opposite: simple interest.
In a simple interest account, the interest you earn on the account is only calculated using the initial principal. So, consider a US treasury security for example. The interest earned on that is simple, thus if you buy a $100 treasury note at 3% interest, you get $3 per year no matter what. Thus after 10 years, you have $130.
In compound interest, the interest you accumulate is added to the principal, thus the interest earned increases year over year. So, consider putting $100 in an account that earns 3% compounding per year. After the first year, you’d earn 3% interest and thus get $3. But the second year, you get 3% interest on $103, not just $100. Thus you’d get $3.09 of interest rather than just $3. And this builds year after year. Thus, after 10 years, you have $134.39.
If you are thinking about investing for retirement, then it’s not “compound interest” but rather “compound growth.” The idea is exactly the same as the interest examples you are getting, but you won’t find something to invest in that gives interest directly.
The idea is just that if a stock grows 10% one year and 10% again the next year, then the second year’s growth is ***11%*** of the first year’s price. This is because in the first year it goes from 100% to 110% (+10% of 100%) and in the second year it goes from 110% to 121% (+10% of 110%).
Compound interest is just the principal that interest earned in one year also earns interest in subsequent years if you allow it to just be added to the pot.
You have $100 earning 5% annually. At the end of the year you have $105. In year two, that $105 earns 5% interest, or $5.25 in interest. In year 3, you have $110.25 earning interest. And so on… While only a small difference early on, as the interest grows over time, the amount of benefit from compounding grows, too.
Imagine for a moment that you find a bsank that will pay you 100% interest per year. Their brochure says put £100 in today and next year we’ll add £100!
It’s a wonderful deal and you put your money in. One year later the interest gets paid and you immediately withdraw the interest and have a proper night out. You leave the original money in because next year you can do it again! After 5 years you close the account, pocket your original £100 with a big smile and remember your 5 free nights out…
Meanwhile your twin started out the same way but didn’t fancy the nights out (probably because you took them with you cos you’re nice) so they just left the interest in the same account and every year it doubled. When your twin closes their account they need a suitcase .. because .. 100 became 200 became 400 .. 800 .. 1600 … £3200.
That’s the difference .. 2% is a much smaller return .. but it still works the same way .. it just takes longer to get to the big numbers.
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