Investopedia defines compound interest as interest calculated on the initial principal, which also includes all of the accumulated interest of previous periods of a deposit or loan. Thought to have originated in 17th century Italy, compound interest can be thought of as “interest on interest,” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.
Compound interest is a relatively simple concept. It is, essentially, interest on top of interest on top of interest on top of – you get it right? As part of a long term investment strategy it can yield incredible results. Albert Einstein described it as the most powerful force in the universe and as the 8th wonder of the world.
A K100,000 investment that yields 10% simple interest per annum over 5 years would lead to a K50,000 return on investment over 5 years or a 50% return.
A K100,000 investment that yields 10% compound interest per annum over 5 years would lead to a K61,051 Return on investment over 5 years or a 61% return.
The simple example above shows how much of a difference compound interest can make over a period as short as 5 years. Over a longer period of time, the difference would be even more significant. This is why compound interest could make all the difference when planning for the long term and future expenses like children’s university fees or retirement.
While the effect of compound interest on savings/investments is a positive one, the opposite can be said on a loan that utilises compound interest!