What are compound interests?
Compound interest is the sum of interest earned on an initial capital as well as on the interest accumulated over time.
Unlike simple interest, where only the interest on the initial capital is calculated, compound interest regularly "capitalizes" the already accumulated interest, thus allowing the capital to grow in an exponential manner.
How does compound interests work?
To illustrate this concept, let's take a simple example: suppose you invest CHF 10,000 in life insurance at an annual interest rate of 5 %. If the interest is compounded annually, at the end of the first year you would have :
- Initial capital : CHF 10,000
- Interest for the 1st year : 10,000 CHF × 5 % = 500 CHF
- New capital : CHF 10,500
To calculate compound interest over 10 years, while maintaining an interest rate of 5%, we use the following formula:
Cₙ = C₀(1 + t)ⁿ, where
: Future value of capital after " " periods.
: The initial capital or starting amount.
t : The interest rate per period (expressed as a decimal, e.g. 5 % = 0.05).
n : The number of periods during which capital is invested or capitalized.
For the second year, interest is calculated on the CHF 10,500, and not only on the initial capital:
- Capital after 2 years : 10,000 CHF × ( 1 + 5 %)^2 = 11,025 CHF
The effect of compounding becomes increasingly noticeable as the years go by, significantly increasing the total amount accumulated over time.
- Capital after 10 years : CHF 10,000 x (1 + 5%)^10 = CHF 16,288.95
How can I benefit from compound interests?
Traditional savings accounts offer a high level of security and liquidity, but in return offer very low interest rates.
Consequently, compound financial products such as investment funds, retirement savings plans (like the 3rd pillar), and even stock market investments often offer higher returns thanks to the effect of compound interest, although they are also more risky.
The timing of compound interest
Time amplifies their impact. An investment of 10,000 CHF at an annual interest rate of 5% over 10 years grows to approximately 16,289 CHF. However, if the investment is maintained for 20 years, it reaches nearly 26,533 CHF, thus demonstrating the power of the multiplier effect in the long term.
Regular investments can also be very effective. For example, investing 5,000 CHF each year for 20 years at a 5% rate could result in a final capital far exceeding the initial contributions, thanks to compound growth.
