Calculating Interest 2: Compound Interest

I previously talked about simple interest. Simple interest means that the principal is the only thing that creates interest. But that interest doesn’t create more interest.

Compound interest is different. Instead of distributing the interest to the investor, compound interest adds the interest to the principal. And then that interest creates more interest. So the interest compounds.

For example, you invest $10K at 5% compound interest for 10 years. Each year the interest gets added to the principal and grows. In the first year, you’ll get 5% of the $10K, which is $500. Add that to the principal for a total of $10,500. In the second year, you’ll get 5% of the $10,500, which is $525. Add that to the principal for a total of $11,025. After 10 years your $10K will grow to $16,289.

Compare that to simple interest which would give you $500 per year. So your total after 10 years is only $15,000. Compound interest wins.

This is particularly striking over longer periods of time. If you were able to compound the above example for 40 years instead of only 10 years, your $10K would be worth $70K. But if it was simple interest, it would only be worth $30K. Simple interest ends up with less than half.

Compound interest is the holy grail of investing, but it’s hard to find. Most investments make money one year and lose money another year, so you can only calculate compound interest after the fact. Or you can guess future compound interest based on a historic track record.

Also, if you don’t pay your debts, they start to compound. Credit card debt, for example, isn’t as low as 5% interest. It’s more like 20%+. $10K at 20% for 40 years is almost $15 million. Ouch.

Here’s the formula: Future Value = Principal x (1 + Rate) ^ Time. For the above example, $10K x (1.05) ^ 10yrs = $16,289.

What do you think?
Joseph

This is a series. Here is the previous post. Here is the next post.