Article | 2:07 min read

Compound Interest and Why it’s Important

Investing

Often referred to as the “eighth wonder of the world,” compounding interest lets your money work for you.

Lego blocks arranged from shortest to tallest

What is compound interest?

Compound interest is the interest on a deposit calculated based on both the initial principal and the accumulated interest from previous periods. [1] Or, more simply put, compound interest is interest you earn on interest . You can compound interest on different frequency schedules such as daily, monthly or annually.

The higher the number of compounding periods, the greater the compounded interest. Think about it like a snowball. The sooner you start saving, and the more money you add to your snowball, the larger it will grow. Now, think about if you pushed the snowball down a snow-covered hill. Now the snow you already packed will stay, and you’ll accumulate more snow. Eventually, when your snowball reaches the bottom of the hill, it will contain the snow you started with, the snow it picked up along the way, and even more snow on top of that.

In other words, the interest-on-interest effect can generate continually increasing returns based on your initial investment amount. So, the more frequently you save, and the larger the amount you save, will return larger amounts of interest. This is also called “the miracle of compound interest.”

Why is compound interest important?

Compound interest causes your wealth to grow faster. It makes a sum of money grow at a faster rate than simple interest because you will earn returns on the money you invest, as well as on returns at the end of every compounding period. This means that you don’t have to put away as much money to reach your goals!

The magic of compounding can be an important factor when building your wealth. The earlier you open an interest-bearing account and start stocking away money, the more money you will earn in compound interest. It’s also key to helping mitigate wealth-eroding factors like the rising cost of living, inflation, and reduction of purchasing power.

How to calculate compound interest:

Compound interest is calculated by multiplying the initial principal amount by one, plus the annual interest rate, raised to the number of compound periods, minus one.

When calculating compound interest, the number of compounding periods makes a significant difference. The higher the number of compounding periods, the greater the compound interest.

Make it easy - use this calculator to calculate compound interest!

Be sure to consult with your tax advisor or financial advisor on the best way for you to get started. As always, we are here to help! Contact us or visit your local Central Bank with any questions.

Sources:

[1] Compound Interest, Investopedia

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