What Is Compound Interest? Explained

Compound interest is, in short, the interest accumulated on interest. For instance, you have a £10,000 investment with a 10% return. The £1,000 return you then have goes back into the investment so next time you have a 10% return on £11,000 which is £1,100. When you look at it like this is not very complicated at all. You invest your returns back into the investment and the returns increase.

Compound interest explained

Compound interest also known as the get rich slow scheme. I was doing some research on the definition and felt like I was taking an algebra lesson. So, I thought I’d put this article together to simplify it.

Compound interest is, in short, the interest accumulated on interest. For instance, you have a £10,000 investment with a 10% return. The £1,000 return you then have goes back into the investment so next time you have a 10% return on £11,000 which is £1,100. When you look at it like this is not very complicated at all. You invest your returns back into the investment and the returns increase.

How to take advantage of compound interest

One of the best ways to take advantage of compound interest is through index funds. An index fund for those of you that don’t know is an investment portfolio made up of a number of companies. Using index funds is beneficial because they are typically more secure than individual stocks.
You’ll invest in an index fund at high risk with a good return or low risk with low returns. The interest made on the investment is paid back into the investment to compound.
I have to mention that this is not a quick process, as I mentioned at the start its also know as the get rich slow scheme. Your typical return is calculated yearly so it will take years for your money to compound. This is not a get rich quick scheme.

How compound interest is calculated

If you are interested in sources that will calculate it for you, sites like
Financial-Calculators.com, Investor.gov and TheCalculatorSite.com all have great tools that will do a great job.

If you are more interested in how compound interest is calculated and the mathematical aspects on it check out the WIKIPEDIA page. They have very in-depth examples that make me feel like I’m back in school, enjoy.

It’s not that I don’t want to show you, I just wouldn’t do it any justice 🙂 See below for examples that explain.

How compound interest is different from simple interest

Compound interest, interest on interest.

Simple interest is interest on the initial investment.

So back to our example where we have £10,000 invested and a 10% return of £1,000. The simple interest is £1,000. With simple interest, the £1,000 is usually taken away from the investment so the return is always calculated in the initial £10,000 investment.

You can see now how compound interest will benefit you more in the long run because of the increased return on interest.

Why Compounding Periods matter

Compounding period is the frequency that your interest is calculated. This is typically quarterly (4 times a year) or annually (once a year). This matters because the more frequent your compounding periods are the more money you will earn.

Let’s compare annual and quarterly periods. This might be the same investment with the same return. Let’s go back to our previous example, a 10% return on a £10,000 investment annually.

If the compound period is annually or once a year. In this case, you have one 10% return of £1,000.

On the other hand, if your compound period is quarterly or 4 times a year. The investment is calculated 4 times at 2.5%. Now, this might not sound great but look at what happens.

First Quarter £10,000 + 2.5% = £10,250
Second Quarter £10,250 + 2.5% = £10,506.25
Third Quarter £10,506.25 + 2.5% = £10,768.90
Fourth Quarter £10768.90 + 2.5% = £11,038.13

Over as short a time as just one year, you can see how much better off you can be. In this case, £38.13 better off. If we calculate the same over say 40 years with just our £10,000 and the 10% return.

Yearly compounding
£452,592.56

Quarterly compounding
£519,778.68

As you can see over the short term it might not make much difference to you. But in the long run not checking the compounding periods could mean a difference of £67186.12 over 40 years. Just keep in mind that the more often your money is compounding the better.

How can compound interest help you

This question should really be “How I can use compound interest to help myself”. If you have ever heard of Warren Buffet, you probably know this is how he became so rich. He often says he had some luck and then all he did was wait 50 years for it to compounding.

Now obviously I’m not saying in 50 years you’ll be as rich as Warren Buffet but why not follow in his footsteps. As I mentioned in the section how to take advantage of compound interest index funds are the way to go. Pick a good index fund with Vanguard or similar accounts that will let you take advantage of compound interest. Keep contributing to it as often as you can and watch it grow.

The trick is to start now. Compounding is your best friend so the more time your money is in the account the more it can compound and grow.

So I hope you are now a bit more clear on compound interest and how you can use it to grow your wealth. If you have any questions or thoughts leave a comment below and I’ll do my best to answer them 🙂 Happy Saving!

Leave a Reply