Compound interest makes the world go around

  • By Carole Ann Furman

  • August 1, 2018
  • 6:59 pm BST

Compound interest, whether it is from a personal savings, investment or wealth creation strategy point of view, is so fundamentally important to grasp that it warrants more than just a two-sentence explanation. There is a good reason that one of the brightest minds that ever lived, Albert Einstein, called compound interest the “eighth wonder of the world”.

What is compound interest?

The short answer is that it is interest on interest. Compound interest is interest that is not withdrawn by you, but gets added to the initial sum of money that generated the interest. It is one of the critical components of making money work for you instead of the other way around.

Looking at our definition, if interest is paid out monthly, then in month two, interest equals the interest on the initial capital from month one plus interest from month one. In month three, interest equals the initial capital from month one plus interest from month one in addition to interest from month two. This can be slightly confusing, so let’s use an example with numbers.

Compound interest example

If you have a sum of $10,000 that attracts interest at 10% per year ($1,000 per year) and you decide to withdraw your interest instead of reinvesting it so it attracts more interest, at the end of five years, you would have $15,000 – your $10,000 capital plus $1,000 withdrawn every year.

If you had instead decided to let compound interest accrue, your total capital over five years would have been $16,105.10. That’s $1,105.10 more.

Let’s look at what happens when another five years pass. You now have $20,000 instead of $15,000. However, if someone else had decided to leave the interest and let it compound, they would have reached $25,937.42.

After yet another five years, here is where it really starts to get astonishing. You would now have $25,000. Had you let the interest compound, you would have an astounding total of $41,772.48. Over 40 years, there is no question that it is worthwhile as the accrued capital becomes so substantial.

Time heals everything

They say that time heals everything, but who would have thought it could heal the hole in your pocket? As the above scenario illustrates, the critical factor is time. Time is needed for compound interest to reach maturity and have an impact.

This same time and compound interest can be used to great effect in copy trading and social trading strategies. Once you learn how to trade CFDs, you will also get to know how to do so when using social trading strategies such as this one.

When you open your account, it will automatically operate at a certain capital weight that is decided by taking into account the size of your capital, your copy ratio and your risk level, among other factors.

If you get a monthly return of 6% and leave this to accrue on your account, you’ll then be able to increase the weight of the operations at some point. Your interest will have accumulated handsomely (assuming you left it to compound), adding up to a much meatier chunk of capital.

Once you’ve also mastered the art of paying yourself first and then adding to it what you know about compound interest, you’re well on your way to mastering one of the greatest trading tips of all: making money work for you. Compound interest and harnessing the power of it is one of the major factors that distinguishes diligent savers and investors from really smart and successful ones.