To put it simply – compound interest is when interest earns interest.
Compound interest is the result of reinvesting interest, rather than paying it out, so that interest on the next period is then earned on the principal sum PLUS the previously accumulated interest.
The table on the right illustrates the powerful effect compounding can have on the investment returns of a portfolio.
The result over time has a snowball effect, where the portfolio starts growing quicker and quicker the longer it is invested.
The benefits of compound interest require patience and time. This scares many people who live in a world where everything is instant and they are looking to make a quick buck. Nonetheless, the returns that compounding creates over time are well worth the wait.
The financial world often refers to compound interest as ‘magic’ because it is one of the most fundamental ways to build wealth, yet takes the least amount of effort.
The example on the right shows the gains of two portfolios called the ‘Spender’ and the ‘Compounder’. The Spender spends all the interest that is earned and the Compounder reinvests all the interest that is earned. The differences in the gains of the two portfolios becomes even larger as time goes by.
Over a 20-year period, the Compounder’s portfolio gain is more than FIVE times the gain of the Spender’s portfolio.