Compounding Explained

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When saving or investing, high rates of return are always attractive. However, there are subtle differences found in the small text that will have a profound impact on your future wealth. Certain aspects worth noting are the type of interest, and the period over which the interest is paid.

The two types of interest are ‘compound interest’ and ‘simple interest’, which provide similar returns in the short term, but can differ significantly further down the line.

With simple interest, an investor receives a flat-interest rate on the principal amount in their account. Therefore, no matter what the current value of the account is, the return will always remain the same.

Compounding, or compound interest, is interest calculated on both the principal value, and the accumulated interest of previous periods. It is an excellent investment vehicle, and can be thought of as ‘interest on interest’. For example, an initial investment of £1,000 with an annual interest rate of 10%, would increase by £100 in the first year. In the second year, the interest rate of 10% is applied to the entire £1,100, leading to an increase of £110. The rate of growth due to this compounding effect will continue to follow this exponential trend, and is important in the long term to significantly boost investment returns.

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However, when related to interest paid on loans, compounding can be a dangerous path to severe debt. The average American household credit card debt is $8,377, and the average card APR is at 15.07%. If this were allowed to compound over a period of 10 years, the bank would be owed $37795 (4.5 times the initial value). It is because of compounding that debt can be such a dangerous hole to get into.

When considering the effects of compounding, it is worth noting that the compounding period can have a noticeable effect. An annual interest rate of 12% paid monthly is the equivalent of having a monthly interest rate of 1%. Due to compounding, the actual annual return comes out at 12.68%. The effect of this simple change in compounding period can be seen in the graph below.

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If the interest rate is fixed and paid annually, there is a simple trick for calculating how long it will take for your initial investment to double. Known as the ‘Rule of 72’, it simply requires you to divide 72 by the interest rate to give the approximate period in years needed for it to double.

Compounding is important in mitigating wealth-eroding factors. It can counteract inflation, protecting your assets and securing your financial future. Make the most of compound interest by investing early, and reap the benefits further down the line.

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