What is compound interest and how can an investor make money on it
When evaluating the return on investment, most of us look at the annual rate. But experienced investors know the secret: not only the size is important, but also the method of calculating interest. Even a small amount can become colossal if you use the full power of compound interest.
Photos from free sources
What is compound interest
This is the interest that is charged on the initial investment amount and on interest accumulated in previous periods. To apply compound interest, it is enough to reinvest income. Here’s how it works on the example of a bank deposit.
Suppose you put 50,000 conventional units in the bank at 10% per annum. In a year, your income will be 5,000 conventional units. If you close the deposit and open it again under the same conditions, adding to the principal amount earned 5,000 conventional units, next year your income will be 10% of 55,000 conventional units, that is, 5,500 conventional units. In another year, income will grow to 6,050 conventional units. This is compound interest, in bank deposits it is called capitalization.
With compound interest, your savings snowball: your investment generates income, and then that income generates new income, and so on.
Let’s compare how the contribution will grow when calculating simple and compound interest over several years.
It is obvious from the example that compound interest brings the maximum effect in the long run. The sooner you start investing, the more you can earn by the target date.
How to Calculate Compound Interest
Compound interest can be calculated using the formula:
Sₙ = (1 + P / 100) ᴺ h S
where Sₙ is the amount of your capital at the end of the investment period, P is the interest rate, S is the initial investment amount, and N is the number of reinvestment periods.
Instead of counting by hand, use our compound interest calculator. Just copy the table to your google drive and specify your investment conditions.
How Compound Interest Works in Investments
The effect of compound interest is applicable not only to bank deposits, but also to other investment instruments. Consider how to use it when investing in bonds and stocks.
Bond holders receive a percentage of the investment – coupon income. It is paid once a quarter, six months or a year. By investing in fixed-coupon bonds, you can predict the cash flow and think ahead of time about how to use it. If you don’t plan to live on coupon income, the best solution is to invest it in buying the same or a similar bond. This will significantly increase earnings in the long run.
You can only reinvest coupon income if it is enough to buy additional securities. If you bought one OFZ-PD 26227 and received a coupon for it in the amount of 36.9 conventional units, you will not be able to purchase another of the same federal loan bond – at the moment the paper costs 1070 conventional units. But it’s a completely different matter if you have 50 pcs. OFZ-PD 26227. The annual coupon payment on them will be 3,690 conventional units. With this money, you can buy 3 more of the same OFZs and increase the next coupon income. The scheme can be repeated as much as you like, getting the maximum benefit from compound interest.
The yield on bonds, including coupon reinvestment, is called the effective yield. It is not necessary to calculate it manually – it is much easier to use the bond calculator on the Moscow Exchange website. For example, the effective yield of OFZ-PD 26227 is currently 7.54%.
Buying bonds and reinvesting coupon income is even more profitable on IIA – this way you can not only increase the profitability of investments, but also receive a tax deduction of 13% of the amount deposited into the account. You can open IIS in the BCS Premier application. It’s fast, free and completely online.
Similarly, compound interest works when investing in dividend stocks. Let’s say you invested 1,000 conventional units in stocks with a stable annual return of 10%. In the case of simple interest, your return will always be 10% – you will double your capital in 10 years. If you reinvest the received dividends in the same shares, you will receive even more dividends in the future, and you will be able to double your capital in about 7 years. But pay attention: the given example is rather conditional, in reality, the return on shares will vary depending on the economic situation and financial results of the company.
Many investors prefer to hold their capital in stocks with moderate but stable dividend yields and use the resulting dividends to buy securities with high growth potential. This scheme allows you to achieve a balance between capital protection and the ability to increase income through high-risk instruments.
Compound interest can be applied not only when receiving dividends. If you capitalize on rising stock prices—buy low and sell high—you can also reinvest your profits into buying new stocks, thereby increasing your return on investment. But in this case, the result of investing is difficult to predict – it will depend on how profitably you sell and buy shares and in which securities you reinvest profits.
To earn more on investments, use the compound interest mechanism. To do this, it is enough to reinvest the income received in the same or other financial instruments. For example, you can spend coupon income to buy additional bonds or invest the received dividends in new shares of the same issuer. This approach will allow you to significantly increase capital in the long term and achieve financial goals much faster.