Compound Interest: How Does It Work?
Compound Interest are a smart way to save money and earn a higher return. Generally speaking, when you invest a sum of money, you receive interest on it every year.
In the case of compound interest, if you leave it on your account, it is added to your capital. In other words, you can earn interest every year on your interest.
Another way of thinking about it is to see compound interest as a snowball that gets bigger and bigger as it rolls along.
What's the Difference between Simple and Compound Interest?
When you place money in the bank and receive interest on it, you can receive both simple interest and compound interest.
Simple Interest
Simple interest is calculated on your initial capitalThis is the amount you invested in the first place. Unlike compound interest, simple interest is not added to the principal, so you'll receive the same amount every year.
For example, if you have invested CHF 1,000 in an account with an interest rate of 5%, you will receive CHF 50 each year.
Compound Interest
Compound interest, on the other hand, is more advantageous. Instead of being based on the initial capital invested, compound interest is added to the capital each year. The interest received is then calculated on this new total.
To return to our previous example, if you invest CHF 1,000 with an interest rate of 5%, you'll receive 1,050 in the 1st year, which will be your new total. The following year, you'll receive 5% of 1'050, equivalent to CHF 52.50, and so on.
How do I Earn Compound Interest?
To receive compound interest, you'll need to deposit an amount in an account. You don't need to deposit a very large sum to receive compound interest. For example, you can invest in :
- A savings account
- An investment fund
- A long-term savings plan (retirement)
- Compound interest bonds
Advantages and Disadvantages of Compound Interest
Capital Growth
While there are many advantages to compound interest, there are also disadvantages to consider. The main advantage, of course, is that you can receive more than the same fixed amount each year, allowing you to earn more on long-term investments.
Long-Term
On the other hand, when you invest in an account or an investment with compound interest, one of the main advantages is that it's easy to earn interest. The disadvantages is the time it takes to receive a significant return. In fact, the longer it takes, the more money you'll receive.
On the other hand, if you don't wait and withdraw the money every year, you won't receive a very large sum. So make long-term investments instead, like for your retirement, for example.
Interest Capitalization
If the sum of money involved is similar to a loan, it is often disadvantageous to have compound interest. This is because unpaid interest is added to the principal owed, and in turn generates interest. In other words, the borrower pays interest on interest that has already accumulated and that increases debt.
How to Calculate Compound Interest
Formula
To calculate the amount of return you can expect, apply the following formula: A=P⋅(1+n/r)n⋅t
Defining Variables :
A Final amount after t years.
P Initial capital invested.
r Annual interest rate (expressed as a decimal, e.g. 4% = 0.04).
t Duration of investment in years.
It is also possible to use a calculator for compound interest, which is simpler to use.
Sample Calculation
Suppose you invest 200 CHF at an annual interest rate of 4% for 5 years.
The calculation would be :
A = 200⋅(1+0,04)5
Calculation of 1+0,04 = 1,04.
Rise to power 5 : 1,045 = 1,21665.
Multiplication by initial capital : 200⋅1,21665 = 243,33 CHF.
The final amount after 5 years will then be 243.33 CHF, which represents 43.33 CHF compound interest. So you can see that it's more advantageous to have compound interest on long-term investments.
Frequently Asked Questions
What is compound interest and how does it work?
Compound interest allows you to earn interest on your initial capital as well as on the interest you've already accumulated. The longer you leave your money invested, the more it grows, a bit like a rolling snowball.
Why is compound interest more advantageous than simple interest?
Unlike simple interest, which is calculated only on the initial capital, compound interest is added to the capital every year, generating even more interest over time.
How does compound interests work?
Compound interest is added to the capital every year, which means that new interest is calculated on a larger and larger amount. In this way, the capital gradually increases over time.
What types of investments earn compound interest?
You can earn compound interest by investing your money in :
- A savings account
- An investment fund
- A retirement savings plan
- Compound interest bonds
Why is it worth investing with compound interest?
The main advantage is capital growth: the longer you leave your money invested, the more interest it earns, increasing your earnings over the long term.
What is the formula for calculating compound interest?
The formula is : A = P (1 + r/n)^(n*t)
- A: Final amount
- P: Initial capital
- r : Annual interest rate
- n: Number of capitalization periods per year
- t : Duration of investment
