The concept of compound interest and its implications in investments
In this article the concept of compound interest is going to be explained and some of its applications exemplified. Its use is going to be analysed briefly in order to understand if it really is a useful concept for the world of finance and also day-to-day activities of small investors.
What Albert Einstein once defined as “the greatest mathematical discovery of all time” is in fact a simple but very important and effective concept. Both in finance and in every day use, it is important to understand the concept of compound interest.
The purpose of investing money is to earn interest on capital. In the first year of investment interest is earned on the sum of capital invested. In the second year interest is earned both on the original investment and on the interest from the first year. In the third year interest is earned on capital and on interest of the first and the second year. And so forth.
Compounding is the process of earning interest on interest. It works with a snowball effect: the more time passes, the more money is going to accumulate through mathematical progression.
The effects of compounding can be appreciated the most in a situation with the following characteristics:
1) an investment started early is more likely to generate positive results: investing £100 a month from age 20 to 30 and then letting the investments grow is likely to result in more money at the age of 60 rather than an investment of £100/month started at 30 and until the age of 60. This makes it worth while to do the calculation whether you are investing in shares or simpler products such as equivalent life cover policies.
| Provider | Equivalent Product | Monthly premium | |
| Friends Provident | Protection | £5.00 | |
| ASDA Finance | Life Insurance | £6.85 | |
| Scottish Equitable | Individual Protection | £7.50 | |
2) as compounding is a process which is best seen over long periods of time, it is also to be noted that, especially in the long run, the amount of interest rate makes a big difference: investing at 7% might not seem very different from investing at 8%, but makes all the difference in the long term.
3) in the long run, investing relatively small amounts of money on a regular basis can make a huge difference: the “snowball effect” is best to be seen over a considerable amount of time.
A very simple, basic way of calculating the effects of compounding is known as the “rule of 72”. The idea of the rule of 72 is to find out how long it would take for an investment to double. It consists in dividing the percentage rate of growth by 72. Thus, if an investment has a growth rate of 8%, it will take for it 9 years to double (72/8=9). An investment which has a growth rate of 12%, will take 6 years to double (72/12=6).
Whilst this calculation only provides approximate values, it is a helpful tool to evaluate the possibilities of certain investments and financial products such as loans where the small differences in interest rate can (2.4% in between cheapest and most expensive in this example) can amount to a large difference over the years.
PRODUCT |
APR |
| Zopa (Typical 5.7% APR) | 5.50% |
| First plus (Typical 6.7% APR) | 6.70% |
| Tesco (Typical 6.8% APR) | 6.80% |
| MoneyBack (Typical 6.9% APR) | 6.90% |
| Alliance and Leicester (Typical 7.7% APR) | 7.70% |
| Lloyds TSB (Typical 7.9% APR) | 7.90% |
| Barclays (Typical 7.9% APR) | 7.90% |
| J Sainsbury (Typical 7.3% APR) | 7.30% |
| M & S (Typical 8.9% APR) | 8.80% |
| Norton Finance (Typical 13.9% APR) | 8.90% |
| Central Capital (Typical 14.9% APR) | 8.60% |
| Blackhorse (Typical 10.9% APR) | 8.40% |
| Welcome(Typical 22.1% APR) | 9.90% |
| Norton Finance(Typical 16.4 APR) | 12.40% |
| CitiFinancial (Typical 23.1% APR) | 23.10% |
*Souce of data, Beat That Quote, Loans 24/04/08. Data accurate at time of writing
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