Compound interest is the additional interest payment that is accrued based on the addition of past interest payments onto the original principal amount.
Compound interest is considered to be one of the most important features of finance, as even small initial principal amounts can grow exponentially over many compounding periods. Similarly, the contrast between a compounding and non-compounding deposit where all other terms are equal is stark, particularly over longer time frames and a higher number of compounding periods.
Compound Interest Example
Take two bank deposits that are the same in every way except that one is compounding and the other is non-compounding. The initial principal amounts are $1,000, the interest rate is 10% annually and the deposit term is 2 years with one interest payment each year.
The interest payment for both deposits would be the same after the first year. Both deposits would receive 10% of $1,000, or $100.
The interest for the non-compounding deposit would be paid out to the depositor, while the interest for the compounding deposit would be added to the original principal of $1,000, resulting in a deposit of $1,100 for the next interest payment period.
At the end of the second year the non-compounding deposit would again receive an interest payment of 10% of $1,000, or $100. The compounding deposit, on the other hand, would receive an interest payment of 10% of $1,100, or $110, with the additional $10 being the result of compound interest.
The Importance of Compounding Periods
The difference between compound interest payments may seem small over a small number of compounding periods, but its impact grows exponentially the greater the number of compounding periods.
Take our previous example, but stretch the payments out over 30 years instead of 2. After 30 years the non-compounding deposit would have accrued $3,000 in interest payments. On the other hand, the compounding deposit would have accrued $16,449 in interest payments over the same period.
As an additional note, if the same annual rate had been split over monthly compounding periods, the interest accrued would have been $18,837. The same annual interest rate for the same number of years, but a greater number of compounding periods would lead to an additional ~$2,400 in interest payment.
Compound Interest and Retirement Investing
Prudent retirement planning usually looks at a 30 year investment period before retirement draw-downs begin. Therefore, over such a long period, the power of compound interest can significantly impact final retirement outcomes for investors.
The sooner an investor starts saving for their retirement and the more of their investment earnings that they reinvest, the more the power of compound interest will dramatically increase their retirement outcomes.
Final Thoughts
Compound interest is a simple mathematical result that has a dramatic effect in the investing world. The impact of compound interest increases substantially the longer the duration and the greater the number of compounding periods.
Even day traders can profit substantially from the use of compound interest. By reinvesting their daily profits, day traders can significantly enhance their returns when compared to automatically withdrawing any profits accrued at the end of each day.