Understanding Compound Interest

Compounding interest is actually pretty simple to calculate; but what is it?

This objective of this article will not show you how to compute compound interest; rather it will show you why it is beneficial for your overall portfolio.

Compound Interest Is Different From Simple Interest

Consider this

I have $100, and I would like to put it to investing, for the sake of illustration, say getting 20% of interest. In 2 years time, the sum I would have gotten would differ significantly.

Simple Interest

In the first year, I would have gotten $120, with $20 being the interest. And then following that, another $20 dollars as interest. The principle is a consistent $100 through the year. All because of how simple interest are structured. The interest earned, is just interest.

So overall, in the two years, I would receive $100 + $20 + $20 = $140

Compound Interest

On the other hand, were I to put it to compounding interest, things would change slightly for me. In the first year, I would earn the same, $120, with $20 being the interest. Now, in the years that follow after the first, things will diverge, minutely, then significantly.

At the second year, the interest will become the principle, which then is able to earn interest off itself. So, that will be $120 x (1.2) giving us a total sum of $144. $4 more from what we yield from simple interest.

Of course, we do not expect you to cheer over $4 more. But the beauty of compounding interest is it starts to snowball much later; initially there is not much you can see.

Logarithms and Compound Interest

If you understood indices or exponential (35 = 3 x 3 x 3 x 3 x 3) when you were taught during school, then the concept of compound interest is only an extension of it into finance. It is a simple function of mathematics, where you multiply the number by itself, or this case, the interest by itself.

This is where the cash is made, compounding provides the snowballing effect for you, and all compounding interest requires you to do is start young. If you do not believe me, just press your calculator to compute and see.

Do I Need to Know These?

Not if you have to, there are many, and I mean many online calculator that can compute compound interest.