What is compound interest and how does it work?
Compound interest is a popular concept heralded as a strong ally in long-term wealth generation. With consistency and time, an initial sum or adding regular amounts – invested or saved – can grow exponentially. Commonly associated with savings, compound interest can also apply to stocks and investing over the long term.
What is compound interest?
Compound interest is a process in which an initial sum (principal) grows through earned interest on both the initial sum and accumulated interest.
When utilised correctly, compound interest creates a snowball effect – over time, you earn interest on increasing amounts, leading to exponential growth. It’s the financial equivalent of a ripple effect, where each wave adds more momentum.
Let’s look at the basic concept in practice:
Data for your calculations | Otherwise known as | |
|---|---|---|
Amount you start with | $2,000 | The principal or the initial sum of money before any interest is applied |
Applicable interest | 6% | The interest rate applied to the principal |
Compound frequency | Annually | How often the interest rate is calculated and applied to the principal over a specified period |
First year return | $2,120 | Principal x interest rate 2,000 + (2,000 x 0.06) = $2,120 |
Second year return | $2,247.20 | First year return x interest rate 2,120 + (2,120 x 0.06) = $2,247.20 |
How to calculate compound interest
Understanding how to calculate compound interest can empower you to make better financial decisions and plan for the long term.
The basic formula for compound interest is:
Here’s what each term represents:
- ( A ) = the future value of the investment, including interest
- ( P ) = the principal investment amount (initial deposit)
- ( r ) = the annual interest rate (decimal)
- ( n ) = the number of times that interest is compounded per year
- ( t ) = the number of years the money is invested for
Compound interest example: Suppose you deposit $1,000 into the bank with an annual interest rate of 5%, compounded over 5 years without any additional deposits. Using the formula above see the outcome below:
After 5 years, your initial balance would grow to approximately $1,276.28.
Here’s a simple table demonstrating its year-to-year growth:
Year | Principal/year | Annual interest (5%) | Yearly total |
|---|---|---|---|
1 | $1,000.00 | $50.00 | $1,050.00 |
2 | $1,050.00 | $52.50 | $1,102.50 |
3 | $1,102.50 | $55.13 | $1,157.63 |
4 | $1,157.63 | $57.88 | $1,215.51 |
5 | $1,215.51 | $60.78 | $1,276.28 |
That’s the principle of compound interest. Now, let’s apply the idea to investing.
How does compound interest work with stocks?
Compound interest works a little differently for stocks than a savings account, this is because shares do not generate monetary interest when held. However, while stocks do not generate ‘interest’ per se, the concept of compound interest can still be applicable.
Securities such as stocks and ETFs have the potential to grow in value over time, which can act as a stand-in for ‘interest’ on savings. Consistent investments over the long term can also accelerate potential growth.
Companies that pay dividends to shareholders could also be reinvested to further increase the underlying position.
Let’s have a look at a few examples of how compounding interest works with stocks.
Compound returns for a 5 year investment
Gabriel is looking to invest in the S&P 500, beginning with an initial investment of $5,000. After investing that initial $5,000, Gabriel decides to continue investing $100 every month into the S&P 500.
With regular contributions, that original $11,000 investment reaches a projected return of $15,175.20*.
As we can see, consistency can compound.
*Figure based on S&P 500 historical annualised return rate of 9.6%. Past performance is not a reliable indicator of future performance. Source: Investment Return Calculator
Compound returns for a 20 year investment
Let’s consider a longer time horizon using the same initial investment amount and subsequent contributions as the above example.
Over 20 years, the projected return of your initial $5,000 (without regular contributions) is approximately $29,376*. However, when you factor in monthly $100 contributions, this grows to a projected return of $67,582* over the same timeframe.
From a $29,000 base investment to a projected total of $96,958.41 – that’s the magic of compound interest and long-term investing.
*Figure based on S&P 500 historical annualised return rate of 9.6%. Past performance is not a reliable indicator of future performance. Source: Investment Return Calculator
What are the pros and cons of compound interest?
Discover some of the core pros and cons of compound interest:
Pros | Cons |
|---|---|
Powerful ally for long-term wealth-building Compound interest is an incredible tool for long-term wealth accumulation. With tactical reinvestment of dividends and consistent contributions, your investments could increase exponentially. | Learning the calculations Calculating compound interest can feel complicated, requiring an understanding of principals, dynamic interest rates, frequency factoring, and While online calculators simplify this process, the concept can take time to learn for new investors. |
Greater returns over time As we’ve observed in the above examples, the longer the term, the more significant the return. In short, getting started early and staying consistent achieves greater results. | Returns are taxable Your returns from compound interest are taxable. This reduces the net benefit of the interest earned and should be considered in your financial planning. |
Prevents wealth erosion Inflation naturally erodes purchasing power over time. Compound interest counteracts this when an investment's growth trajectory exceeds the erosion rate. This helps you maintain or even improve your purchasing power. | Requires discipline To truly benefit from compound interest, you need the discipline to leave your capital untouched for extended periods. Frequently withdrawing funds will disrupt optimal compounding, lessening its impact. |
Automation and simplicity Many financial instruments, like savings accounts, automated investment portfolios and certain bonds, compound interest automatically. This helps investors grow their money with minimal effort. Many financial instruments such as savings accounts, certain bonds and portfolios with automated/recurring investing engaged will incorporate interest automatically. | Risk of loss Investable securities including stocks, ETFs and bonds are subject to market volatility. While potential long-term gains are enticing, you should always consider the financial risk of investing capital. |
Encourages financial responsibility Knowing that your money could grow exponentially with the help of compound interest can be a fantastic motivator to be responsible and considerate of your finances. |
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🎓 Related: How does DCA investing work?→
Do you earn compound interest on stocks?
Stocks don’t earn compound interest the same way cash does in a savings account.
However, unlike cash in the bank, a stock has the possibility of increasing in value over time. Plus, if a stock pays dividends to shareholders, those payments can be reinvested into the underlying position – thus increasing the share ownership and possible returns over time.
If kept consistent over the long term, this strategy could see exponential growth of portfolio value, not unlike a savings account.
Do you earn compound interest on ETFs?
Like stocks, ETFs don’t earn ‘interest’ in the traditional sense.
However, many of them pay periodical distributions to investors which can be automatically or manually reinvested back into the position.
Similar to other investing instruments, there is also the potential for value growth in the ETF itself, which can help with compounding returns.
Compound interest FAQs
The rule of 72 is a novel method to understand the impact of compound interest quickly. With a simple formula, you can estimate how long it will take for an initial investment to double in value at a given annual interest rate.
To use the rule of 72, simply divide 72 by the annual interest rate (I) = I/72.
Let’s look at an example:
You deposit $1,000 into an account with a 6% return. To know how long it would take for that $1,000 to double in value, we’d divide 72 by 6 – giving us a total of 12. This means it will take approximately 12 years for that initial investment to grow to $2,000.
The beauty of rule 72 is in its simplicity. It allows investors to make quick calculations and compare different interest rates and frequencies with ease.
Simple interest is calculated only on the principal, meaning the interest rate applies to only the initial deposit amount. While it still grows, the growth trajectory of simple interest is much more linear, with no accounting for a growing base or long-term viability.
Compound interest calculates interest on both the principal and accumulated interest, resulting in more exponential growth.
The information contained above does not constitute financial product advice nor a recommendation to invest in any of the securities listed. Past performance is not a reliable indicator of future performance. When you invest, your capital is at risk. You should consider your own investment objectives, financial situation and particular needs. The value of your investments can go down as well as up and you may receive back less than your original investment. As always, do your own research and consider seeking appropriate financial advice before investing.
Any advice provided by Stake is of general nature only and does not take into account your specific circumstances. Trading and volume data from the Stake investing platform is for reference purposes only, the investment choices of others may not be appropriate for your needs and is not a reliable indicator of performance.
