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This week we will examine the concept of interest, the sums typically payable when money is borrowed, and as a reward to the lender for taking the risks of lending such money.
What is interest?
Interest is a fundamental concept in finance that plays a crucial role in determining the profitability of investments and the cost of borrowing.
Two of the most common types of interest are “simple interest” and “compound interest”. Simple interest is calculated based on the initial principal amount, whilst compound interest takes into account both the principal and any accumulated interest.
In this article, we’ll further explain the concepts of simple and compound interest, explore how compound interest works, discuss its advantages, and analyse its impact on investment returns.
Simple interest is a straightforward method of calculating interest based on the original principal amount. It is generally used for short-term loans and simple financial transactions.
The formula for calculating simple interest is:
Simple Interest = Principal × Interest Rate × Time
In this case:
Principal is the initial amount of money borrowed or invested.
Interest Rate is the percentage charged or earned on the principal.
Time is the duration of the loan or investment in years.
For example, if you invest $1,000 at a simple interest rate of 5% for 2 years, the interest earned would be:
Interest = $1,000 × 0.05 × 2 = $100
Therefore, after 2 years, the total amount would be $1,100 ($1,000 principal + $100 interest).
Compound interest is a more dynamic and powerful method of calculating interest. It takes into account the interest earned on both the principal and any previously accumulated interest. Compound interest allows for exponential growth over time, making it particularly advantageous for long-term investments.
The formula for calculating compound interest is:
A = P(1 + r/n)^(nt)
In this case:
A is the future value of the investment/loan, including both the principal and interest.
P is the principal amount.
r is the annual interest rate (expressed as a decimal).
n is the number of times interest is compounded per year.
t is the time period in years.
The frequency of compounding, represented by ‘n,’ can vary. It can be compounded annually, semi-annually, quarterly, monthly, or even daily, depending on the terms of the investment or loan.
How compound interest works
Compound interest has a compounding effect on investments due to the interest being reinvested and added to the principal, resulting in greater interest payments over time. As a result, the growth rate accelerates with each compounding period. The more frequent the compounding, the higher the effective interest rate.
For instance, if you invest $1,000 at an annual interest rate of 5% compounded annually for 2 years, the calculation would be as follows:
A = $1,000 (1 + 0.05/1)^(1 × 2)
= $1,000 (1.05)^2
The additional $2.50 is the result of the compounding effect, as compared to simple interest.
Advantages of compound interest
Compound interest offers several advantages over simple interest:
- Accelerated growth: compound interest generates greater growth, allowing investments to grow faster over time. It is particularly advantageous for long-term investments, enabling the compounding effect to magnify returns;.
- Increased wealth accumulation: by reinvesting the interest earned, compound interest aids in accumulating more wealth compared to simple interest. It promotes the growth of investments and helps individuals achieve their financial goals;
- Favourable for lenders: while compound interest benefits investors, it can be a disadvantage for borrowers. Borrowers may face increased interest costs due to the compounding effect, which emphasises the importance of carefully evaluating borrowing options.
Impact of compound interest on investment returns
Compound interest significantly impacts investment returns, particularly over longer periods and across real estate cycles. The compounding effect allows for the reinvestment of interest earnings, leading to higher returns than those obtained through simple interest.
The earlier a person starts investing, the greater the advantage of compound interest. This concept is commonly referred to as “the power of compounding.” By investing early, even relatively small amounts can grow significantly over time due to the compounding effect.
The frequency of compounding also plays a significant role. Investments with more frequent compounding periods, such as monthly or daily compounding, can yield higher returns compared to annual compounding. This is because the interest is reinvested more frequently, resulting in accelerated growth.
To illustrate, consider two investors, A and B, who invest $10,000 each.
Individual A invests in an account with an annual interest rate of 6%, compounded annually, for 20 years. Individual B invests in an account with the same interest rate but compounded monthly.
At the end of 20 years, Individual A would have $32,071.51, while Individual B, benefiting from the monthly compounding, would have $33,614.20. This significant difference in returns highlights the impact of compounding frequency on investment growth.
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CPI Capital believes that understanding the concepts of simple and compound interest is vital for making informed financial decisions and maximising investment returns.
Compound interest offers significant advantages over simple interest, fostering accelerated growth and increased wealth accumulation. The compounding effect amplifies returns over time, especially for long-term investments. By starting early and considering investment vehicles with more frequent compounding, individuals can harness the power of compounding and achieve their financial objectives through passive investments with CPI Capital more effectively.
CIO, Co-Founder CPI Capital