The power of compound interest: How investments grow over time

Compound interest is a powerful financial concept that can help your money grow over time. Earning interest on both the initial amount invested and the interest accumulated in previous periods, compound interest may even get you closer to achieving your financial goals.

Unlike simple interest, which calculates returns only on the original principal, compound interest reinvests earnings, allowing investments to accelerate their growth. However, while compounding can work in your favour as an investor, it can also work against you when it comes to debt, causing balances to swell if left unchecked. So its important to learn as much as you can about this concept so you can stay on track to reaching your financial goals.

What is compound interest?

Compound interest refers to the process of earning interest on both the original amount of money invested (the principal) and any accumulated interest from previous periods. Unlike simple interest, which only calculates returns on the principal, compound interest allows your money to grow faster over time by reinvesting earnings.

Let’s break this down with a comparison example:

• Simple interest.  You invest USD 1,000 at an annual interest rate of 5% over five years. With simple interest, you would earn USD 50 each year, resulting in a total of USD 1,250 by the end of five years.
• Compound Interest. You invest the same USD 1,000 at a 5% annual rate, compounded annually. After the first year, your balance grows to USD 1,050. In the second year, the 5% interest is calculated at USD 1,050, earning you USD 52.50. Over five years, your total grows to USD 1,276.28.

This reinvestment of earnings accelerates growth, making compound interest a critical tool for building wealth.

The compound interest formula

The formula for calculating compound interest is:

A=P(1+r/n)ᶺnt

• A = the total amount after interest
• P = the principal amount (initial investment)
• r = the annual interest rate (as a decimal)
• n = the number of times interest is compounded per year
• t = the number of years the money is invested or borrowed

For example, if you invest USD 5,000 at a 5% annual rate compounded monthly for 10 years:

A=5,000(1+0.05/12)ᶺ(12×10)=5,000(1.00417)ᶺ120≈8,235.05

Your investment grows to approximately USD 8,235, with USD 3,235 earned in interest.

Compound interest can work wonders for your savings and investments but can also increase debt if left unchecked.

How does compound interest work?

Compound interest works by leveraging time, frequency, and rate of return to accelerate the growth of an investment or savings. Its effectiveness depends on how often interest is compounded and how long the investment is allowed to grow.

Key factors influencing compound interest:

• Time. The longer your money remains invested, the more pronounced the compounding effect. A small initial investment can grow significantly over decades, making time the most crucial component.
• Compounding frequency.  Interest can be compounded annually, semi-annually, quarterly, monthly, or daily. The more frequently interest is compounded, the faster your money grows.
  
  For example:
  • A USD 10,000 investment at 5% annual interest over 10 years grows to USD 16,288.95 with annual compounding.
  • With monthly compounding, the same investment grows to USD 16,470.09—an extra USD 181.14.
• Rate of return. Higher interest rates amplify the power of compounding. Even a slight increase in the rate of return can result in a significantly larger balance over time.

The power of compound interest

Compound interest grows your money exponentially over time. The chart below illustrates how a USD 1,000 investment grows over 30 years under different annual interest rates.

Additionally, how often your money earns interest affects its growth, too. Here's an example of USD 1,000 invested at a 5% annual rate over 30 years:

The role of reinvestment and time

The power of compound interest lies not only in its ability to grow your wealth but also in the critical roles of reinvestment and time. Reinvesting earnings ensures each compounding period starts with a larger base, accelerating growth exponentially.

For example, without reinvesting, interest only accumulates on the initial principal, significantly reducing potential gains.

Time, however, is the most powerful driver of compound interest. Starting early enhances the effect of compounding dramatically.

Consider this scenario:

A 25-year-old investing USD 200 monthly at a 7% annual return accumulates nearly USD 500,000 by age 65. A 35-year-old investing the same amount reaches only around USD 250,000 by age 65.

This demonstrates how even a 10-year delay in starting can halve the potential outcome, underscoring the importance of acting early and reinvesting consistently.

Advantages of compound interest

Compound interest provides benefits to the holders of debt instruments or receivers of compounded payments, making it a powerful tool for growth. Here are some of its main advantages:

Accelerates the growth of investments

Compounding grows wealth exponentially by reinvesting earnings. Over time, the reinvested returns generate their own gains, making the overall investment grow faster. Similarly to previous examples, a USD 10,000 investment at 6% annual interest compounded monthly grows to USD 18,194 after 10 years.

Preserves purchasing power against inflation

Investments with compounding returns help protect against inflation, which erodes the value of money over time. By delivering returns that exceed inflation rates, compounding ensures that your savings retain their purchasing power and continue to grow in real terms.

Supports flexible financial goals

Compounding is versatile and supports various objectives like retirement savings, education funds, or wealth-building. Accounts like ISAs or SIPPs broaden its benefits with tax efficiency, making it suitable for diverse financial goals.

Maximises returns through automated reinvestment

Automated tools like Dividend Reinvestment Plans (DRIPs) make it easier to reinvest earnings consistently. By automatically adding dividends to the principal, these plans increase compounding returns without requiring manual effort.

Rewards early and consistent investors

Starting early and contributing regularly dramatically boosts long-term returns. For instance, monthly contributions of USD 300 at a 5% annual return can grow to over USD 250,000 in 30 years. This shows how consistent investments, combined with time, can generate substantial wealth.

Examples of compound interest in real-life

Compound interest impacts everyday financial activities, from growing savings to managing debt.

Savings accounts and certificates of deposit (CDs)

Savings accounts and CDs show how compound interest steadily grows wealth. Banks typically compound interest daily or monthly, enabling even small balances to grow significantly over time.

For example, a USD 10,000 deposit in a CD with a 4% annual interest rate compounded quarterly reaches USD 12,682 after six years. Frequent compounding ensures faster growth compared to annual or semi-annual compounding schedules.

Mutual funds, ETFs, and DRIPs

Mutual funds and ETFs often feature compound interest with reinvested dividends and interest payments. Dividend Reinvestment Plans (DRIPs) automatically reinvest earnings, compounding returns without additional manual effort.

For instance, a USD 10,000 investment in an ETF with a 6% annual return and reinvested dividends can grow to USD 57,435 over 30 years. These options provide a hands-free way to compound wealth over the long term.

Retirement accounts

European retirement accounts, such as ISAs, SIPPs, or company-sponsored pension schemes, maximize compound interest over the long term. Contributions, combined with tax benefits and reinvested earnings, help balances grow exponentially over time.

For example, contributing USD 300 monthly to a pension account with a 6% annual return over 35 years can lead to a balance exceeding USD 400,000. Accounts like SIPPs or ISAs offer additional flexibility, allowing you to choose and manage investments aligned with your goals.

Debt: Credit cards and loans

Compound interest doesn't only grow wealth—it also increases debt balances if left unchecked. Credit cards and certain loans apply compounding to unpaid balances, making them expensive over time.

For example, a USD 5,000 credit card balance with a 20% annual interest rate compounded daily increases to more than USD 6,100 within a year if no payments are made. Similarly, a USD 30,000 student loan with 5% annual interest compounded monthly grows to USD 38,501 after five years of deferment.