Compound interest is the most powerful force in the universe.
Compounding is simply put, the interest which grows over time. And it will be the very factor which will create a big impact if done over a long time, in investing and in long term investing.
Quick, if I were to tell you I want to reach a goal of $380,000 or more and I have $100,000 to invest; I am confident of compounding it for 7% annually in 20 years, will I reach my goal?
The short answer, yes, I will.
Calculating Compound Interest
This is what you do in calculating:
7% equates to 0.07 in interest compound
Invested for 20 years, this interest will multiply itself. So what you get is:
($100,000) x (1.07) = $107,000
($107,000) x (1.07) = $114,490
And so on, multiplying the initial sum of $100,000 by (1.07) to the power of 20, because for each year, your sum will grow by an addition 0.07 or 7%.
To rewrite that above, it is simply ($100,000) x (1.07)20, giving you a total of $386,968.44, rounded up. That way, you excess your initial goal of $380,000. That is simply there is to compounding interest.
Compound Interest Formula
The formula for compounding may thus be summed up as such.
Future Value = pmt (1+i)n
Where pmt being the principal sum, or payment
i being the interest rate (in decimal)
n being the number of years which you leave it to compound
1 representing the initial sum
It is an exponential growth where results are only seen at the later period of investing. Take a look at the graph below, there is your mathematical proof that compounding does the heavy work later than earlier.
The horizontal aix being the time invested, and the verticla aixs being the factor which will eventually be multiplied with your initial sum invested.
The 3 Factors Affecting Your Yield
What changes your overall future yield is thus: the interest you get, the number of years you leave it investing and the principle sum which you invested in initially.
A higher interest rate would mean you take a shorter time to reach your goal (look at the graph in red); with the reverse being true, a lower interest rate left to compound requires a longer period investing (graph in black).
It takes 24 years at 10 percent compound interest to do what 34 years at 7 percent can do, which is to multiply that initial sum invested by 10 times.
It is simple math yet, understand that high interest compound rate generally comes with greater risk. To only look at the interest rate without considering the risk you are about to take is lunacy.