How to reap the benefits of compound interest

Anyone interested in investing should be well-versed in a term that can become their greatest ally: compound interest.

This powerful financial tool can help your assets grow over time. Unlike simple interest, which is calculated solely on the initial principal, compound interest is calculated on both the initial principal and the accumulated interest. This means your money can grow exponentially.

In this article, we’ll explore how you can reap the benefits of compound interest and share some strategies for maximizing its potential.

What is compound interest?

Compound interest is the practice of reinvesting the interest earned on an investment so that over time, the interest itself also earns interest. Simply put, it's "interest on interest."

How do you calculate compound interest?

There's no better way to understand these concepts than with a good example. Imagine you invest €1,000 at an annual interest rate of 10%, compounded annually. After 10 years of simple interest, you'd end up with €2,000, earning €100 in interest each year.

Now let's see what happens when we use compound interest instead. In the first year, you’d earn €100 in interest. So you'd have €1,100. By the end of the second year, you'd have €1,210. You'd earn more interest in the second year (€110) than in the first year (€100) because your interest would keep compounding until you decide to withdraw the money.

Let’s say that after 10 years, you decide to withdraw the €1,000 you originally deposited in your account. By that time, your money would have grown to €2,594. Thanks to compound interest, you'd have nearly €600 more than you would with simple interest.

The basic formula for compound interest

Final capital = initial capital × (1 + annual interest rate) ^ number of years

So if we use the previous example:

Final capital = 1000 x (1+0.10) ^10= 2,593.7 euros

Strategies for getting the most out of compound interest

• Start early: The sooner you start investing, the more time your money has to grow. Even small investments made early on can add up to significant sums over time.
• Reinvest interest: Make sure to reinvest the interest you earn. Many savings plans and investment accounts offer automatic reinvestment options.
• Make regular contributions: Make regular contributions to your investments. Even small monthly contributions can add up over time and benefit from compound interest.
• Diversify investments: Invest in a mix of financial instruments to maximize growth opportunities and minimize risks. Stocks, bonds, and mutual funds are popular choices.
• Avoid unnecessary withdrawals: Withdrawing money from your investments can disrupt compound interest growth. Hold your investments for the long term to take full advantage of exponential growth.

Which products benefit from compound interest?

The answer’s simple: all of them. Compound interest isn’t tied to any one product - it’s a concept. It means reinvesting (or keeping invested) the earnings you make. In other words, some types of investments naturally benefit from compound interest.

One example is a traditional mutual fund (as long as it doesn't pay out income on a regular basis). The interest or dividends generated by the companies the fund invests in are reinvested by the manager, helping the capital to keep growing and increasing its returns.

But this strategy can be applied to any investment product. For example, when you invest in stocks, you can take advantage of compound interest by reinvesting the dividends you receive back into the same company. Similarly, if you invest in Treasury bills, you can use compound interest by reinvesting the interest you earn in your next Treasury bill.