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What is compound interest & how does it work?
Investing Basics
September 14, 2022

What is compound interest & how does it work?

Compound interest can be simply defined as “interest on interest”. The interest accrues on an investment or a savings account that is not withdrawn. This interest is added to the principal balance so that the next time interest is calculated, it is based on a higher amount.

The term "compound" refers to the frequency with which interest is added to an account. The most common compound interest intervals are daily, monthly, and yearly. The earlier you start saving, the more compounding can work in your favor. This is also why you often would have heard people say that the younger you start investing, the better.

How Does Compound Interest Work?

To understand how compound interest works, it’s best to use an example:

Let's say you have a savings account with €1,000, and it earns 10% interest per year. In the first year, you would earn €100 in interest (10% of €1,000), resulting in a total balance of €1,100.

In the second year, you would earn 10% of €1,100, or €110. So your new balance would be €1,210. You can see how your interest is growing each year because it's being applied to a larger principal balance.

Over time, compound interest can have a significant impact on your savings. If you continue to save and reinvest your interest, your account balance should theoretically grow at an accelerated rate.

How is Compound Interest Calculated?

There are particular values you need to consider in order to determine the compound interest. To learn how to calculate compound interest, consider this formula:

A =P(1+r/n)nt

where

  • A = the future value of the investment or loan, including interest
  • P = the principal investment amount (i.e. the initial deposit or loan amount)
  • r = the annual interest rate (as a decimal)
  • n = the number of times the interest is compounded per year
  • t = the number of years for which the money is invested or borrowed

Let's see this formula at work. Assume you invested €1,000 at 10% interest, compounded monthly. The equation would be:

A = 1000(1+.1/12)(12)(5)

A = €1628.89

  • P = €1,000
  • r = 0.1 (10% in decimal form)
  • n = 12 (compounded monthly)
  • t = 5 (years)

Compound Interest Vs. Simple Interest: What’s the Difference?

In comparison to compound interest, simple interest is the interest that accrues on an investment or savings account without being added to the principal balance. This means that each time interest is calculated, it is based on the original amount of money deposited.

With compound interest, the interest earned in previous periods is taken into account in addition to the principal for future calculations. In contrast, simple interest only looks at the principal when calculating future earnings. 

Other Examples of Compound Interest

Compound interest is not only applied to savings but can also be the case with loans. Below are some concrete examples of where you may encounter compound interest in the real world.

1. Mortgage, Student, and Personal Loans

When you take out a loan, the bank will charge you interest on the outstanding balance. This is typically done on a monthly basis, which means that your interest payments will be added to the principal each month.

2. Credit Cards

Like loans, credit cards also work on the principle of compound interest. If you only make the minimum payment each month, the unpaid balance will continue to grow because you will be charged interest on both the principal and any previous unpaid interest. 

3. Crypto Accounts

Some cryptocurrency exchanges offer compound interest on your account balance, allowing investors to earn passive income. This can be a great way to grow holdings without having to do any extra work. 

Given how volatile cryptocurrency assets are, compounding works well in this space since it allows you to reinvest your earnings back into the market. 

Instead of trading manually, you could also try automated trading apps like BOTS.  We have plenty of bots for you to choose from. You only need to select one, fund it, and let our algorithms do the heavy lifting for you. Has this piqued your curiosity? Check out how the BOTS app works and start investing smartly. 

Tips for easing into the world of compounding

  • Start as early as you can. The more time your investment has to grow, the more compounding will work in your favor. 
  • Try to minimize the fees and taxes. Any charges or taxes you incur will reduce the amount of money available to grow through compounding. Hence, you should compare a few different options when it comes to these metrics before you choose an investment option to go ahead with. 
  • Choose a high-yield investment. This will give you a higher rate of return, and compound interest will have a greater impact. 
  • Pay debts as fast as you can. If you took out a loan, focus on repaying the debt as quickly as possible. This will save you money in interest payments, and you can reinvest that money elsewhere.
  • Frequency is key. The more often interest is compounded, the higher your rate of return will be. In the case of loans, the opposite is true - the less frequent the compounding, the lower your payments will be. 

Why is Compound Interest Important?

One of the key reasons compound interest is so important is that it has the ability to turn small investments into large sums of money over a longer period of time. With compound interest, you not only earn returns on your original investment but also on the accumulated interest from previous periods.

Compound interest can either work for you or against you – depending on whether you owe money or are owed money. When lending money, banks, and other lenders will often charge compound interest as it allows them to increase the amount of money they earn from a loan over time.

However, when you are saving money, compound interest can be your best friend as it allows your savings to grow at an accelerated rate.

The Bottom Line

Compound interest is a double-edged sword - it can either be your saving grace or your worst nightmare. Regardless, understanding how it works can help you make the most of your money.

If you know certain tips and tricks, you can make compound interest work in your favor, whether you are trying to save for retirement or simply want to pay off debt.

Disclaimer: 

This blog is for educational purposes only. The information we offer does not constitute investment advice. Please always do your own research before investing. 

Any views expressed in this blog and by BOTS do not constitute a recommendation that any particular cryptocurrency (or cryptocurrency token/asset/index), portfolio of cryptocurrencies, transaction, or investment strategy is suitable for any specific person. 

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