What is Compound Interest?

What is Compound Interest
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What is Compound Interest?

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For those who are new to investing, you’ve probably heard of the term compound interest. Albert Einstein once said that compound interest is the eighth wonder of the world. Why is it such an essential concept to investing that even Einstein believed in it?

In simple terms, compound interest means your interest earns interest. Your principal investment will earn interest, and the interest your investment makes will earn interest, too. Your funds will essentially see exponential growth through compounding.

Compound Interest vs. Simple Interest

You may have heard of simple interest, which differs from compound interest. Simple interest gets calculated from your principal investment amount and any future deposits. Your interest won’t earn any interest, meaning there is no compounding.

By making investments with compound interest, you can plan for your future by envisioning future savings. Setting goals, both long and short-term, allows you to plan for these goals over a certain period.

The Benefits of Compound Interest

No matter what size your investment is, your funds will benefit significantly through compounding, especially if you take a payout at the end of your investment term. The longer your funds are invested, the more time your money can work for you.

Compound interest is one of the most efficient ways to beat inflation. If your interest is not growing, your money won’t get given a chance to work harder for you. Therefore, reinvesting your interest alleviates this risk.

Compound Interest Calculation

To understand compound interest, let’s first look at an example of a simple interest calculation.

Let’s suppose you invest a lump sum of € 5,000 with an annual interest rate of 10%.

After one year: 

Total investment account balance – €5,500.00

Interest earned – €500.00

After five years:

Total investment account balance – € 7,500.00

Interest earned – € 2,500.00

As you can see, the investment has only seen a return on the initial investment and not on the interest.

Now, let’s use the same example as above, but include the power of compound interest.

After one year: 

Total investment account balance – € 5,500.00

Interest earned – € 500.00

After five years:

Total investment account balance – € 8,052.55

Interest earned – € 3,052.55

After five years, there’s a difference of € 552.55 between the simple interest and compound interest examples!

After ten years, the simple interest calculation will look as follows:

After ten years:

Total investment account balance – € 10,000.00

Interest earned – € 5,000.00

After ten years, the compound interest calculation will look as follows:

After ten years:

Total investment account balance – € 12,968.71

Interest earned – € 7,968.71

There’s a difference of € 2,968.71 between the simple interest and compound interest examples after ten years. Time is essential, so don’t waste another day where your money can work for you!

Compound Interest and P2P Lending

One of the most significant features of peer-to-peer lending (P2P) is compound interest. At the end of the term, several investment firms will pay a lump sum interest. Investing in P2P lending allows you to forgo your monthly withdrawals to reinvest the funds.

Factors to Consider

Although you can earn compound interest with peer-to-peer lending, you need to consider a few factors:

  • It’s vital to check with your P2P lender when reinvesting interest and/or capital, as various P2P lenders offer multiple products with different withdrawal and reinvestment features. 
  • Throughout the term, your capital gets lent out several times. If you choose to have your capital reinvested automatically, your total capital and interest won’t always get reinvested.
  • Ensure you’re satisfied with your repayment scheme if you’re manually selecting loans. This will affect your compounding due to certain loans paying back on maturity, quarterly or bi-annually.
  • Compound interest can boost your investment returns but will have little meaning if you get a low-interest rate. To prevent losing out on real terms, ensure your investment scheme’s rate is above the inflation rate.

Final Thoughts

The more funds you have to invest, whether through savings or P2P lending, the more your investment returns can get boosted through the power of compound interest. No matter how much you have to invest, let your money work for you through smart investing.

It’s essential to start investing as early as possible to benefit from compound interest. The sooner you start, the more time your investment will have to grow, and you can expect more in returns.

Don’t let low-interest rates discourage you, as your interest will earn interest over time on top of your initial investment.

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