Basically, Compound Interest tells us that the longer the period you have placed an investment for, and/or the higher the rate of return or interest on that investment, the more it will amount to if you keep reinvesting the interest. And it will grow faster and faster over time (referred to as exponential growth) not just in a straight line.
However, you must keep reinvesting the annual interest you receive or this effect will not happen.
If you invest $100 at 10% for 10 years, you will have $259 at the end of 10 years. If you made the same investment for double the time (20 years) you would actually have more than double the outcome; $673 to be exact.
Alternatively, if you invest $100 at 20% for ten years you will have $619 compared to the $259 at 10% return.
So, either a longer term or a higher rate or both pays off for compound interest.
The lessons we can learn from this relentless growth include:
- You should focus on getting the best interest or return on investment you can within what you consider to be acceptable risk. Each 1% increase in interest/return has a greater than 1% increase in your wealth.
- You will make a lot more from an investment if you can hold it for a longer time. Expressed differently, the sooner you can get a profitable business running and the longer you can run it, the better off you will be – by an exponential factor.
As a sidebar, if you want to impress friends and relations with your ability to calculate compound interest in your head, you should know the “Rule of 72”.
Simply put, your money will double in (72/interest rate) years.
For example, if you invest $100 with compound interest at 9% per annum, the rule of 72 gives 72/9 = roughly 8 years required for the investment to be worth $200.
This can be a handy, quick, calculator when estimating the respective merits of two plans. One that pays 9% per annum doubles in 8 years whereas one paying 6% (which doesn’t seem all that different as a number) takes 12 years to double – 1 and a half times as long.