Compound interest effect: how the turbo works to build wealth
Albert Einstein reportedly referred to compound interest as the eighth wonder of the world. This mathematical effect is one that many people are not fully aware of. According to Christine Laudenbach, Professor for Household Finances at the Leibniz Institute for Financial Market Research SAFE, "its impact is often underestimated. It's not necessarily necessary to calculate it yourself, but you should be aware of its significance." This is particularly important in certain life situations, such as savings and investing.
Compound interest works by helping your wealth grow faster. As Claudia Müller, founder of the Female Finance Forums, explains, "the difference between saving, where you simply put money back, and investing, where your money grows, is that with compound interest, your money earns interest not only on the initial principal but also on the interest earned over time." What may seem simple at first can be difficult for many people to understand.
The Spread of a Virus Follows Similar Mechanisms
We have learned this concept intensively during the Corona Pandemic. The spread of a virus also follows exponential growth, as an infected person can cause multiple new infections. The more people get infected, the faster the virus spreads.
Similarly, compound interest works in investing. Your invested capital grows faster due to the compound interest effect, as not only the initial capital is reinvested, but also the interest earned with it. This means that the interest earnings are a little higher each time.
An example: If someone invests 1000 Euro on a fixed deposit account with a three percent interest rate for a year, they will receive a 30 Euro interest payment from the bank after twelve months. The investor can then consider whether they want to reinvest the original 1000 Euro and receive only 30 Euro in interest again, or if they want to reinvest the interest payments as well. The difference: By investing 1030 Euro, the interest earnings increase to 30.90 Euro. The following year, they could then invest 1060.90 Euro and earn interest on that.
Calculators Illustrate the Effect
What may seem insignificant at first becomes particularly effective with larger amounts and over a long period of time, according to Müller. "With high income, the effect can be used more effectively, as percentage growth becomes more noticeable." Therefore, anyone who already has some money finds it easier to increase it. Above all, if they can keep this money for a longer period of time.
Assuming our saver invests 10,000 Euro at a three percent interest rate for ten years, the compound interest effect would result in over 13,439 Euro on the account after the term. Without the effect, the account balance would only be 13,000 Euro. The difference becomes even more significant over a longer period of time. After 30 years, there would be over 24,272 Euro, compared to only 16,500 Euro without the compound interest effect. Therefore, in this example, the saver would have missed out on over 7,772 Euro in earnings if they did not reinvest their interest.
Not everyone has large amounts to invest, but the interest compound effect works just as effectively for small sums, especially when money is tight. "It's especially important to make use of its benefits in this case," says Laudenbach. To better understand the effect for one's own savings, one can use corresponding tools on the internet - for example, from zinsen-berechnen.de, biallo.de, or Finanzfluss.
Time is a crucial factor in compound interest
Everyone should use compound interest. "Young people benefit particularly from it because they have a lot of time to let it work," says Müller. "This is especially true for retirement savings." And even 50-year-olds can still profit from it. With today's life expectancy, they still have enough time to let their assets grow.
Who has so far put off saving, should also play around with the calculators and find out what difference it makes when one starts saving. For example, if someone saves 150 Euros every month for 30 years at a rate of three percent, they will have more than 87,000 Euros at the end. More than 33,000 Euros of this are earnings due to compound interest. If someone postpones retirement savings and starts five years later, they will only have around 66,700 Euros, of which only around 21,700 Euros are earnings. Thus, compound interest is the best argument for starting retirement savings early.
Yield is a combination of interest and costs
The higher the interest rates, the more pronounced the compound interest effect. Whoever invests their money long-term should therefore pay special attention to possible costs that can arise in the context of the investment, warns Laudenbach. "One should not underestimate the fees. That's like a deduction from the interest." For example, if someone pays one and a half percent in fees per year, they would only have a yield of one and a half percent instead of three percent in our example.
With continuous savings of 150 Euros per month, there would be only around 68,100 Euros left at the end of 30 years instead of more than 87,000 Euros, and with only around 14,100 Euros instead of more than 33,000 Euros in earnings. After 25 years, there would be only 54,600 Euros instead of 66,700 Euros, and instead of around 21,700 Euros in earnings, only around 9,600 Euros.
Compound interest brings enormous benefits to savings. "The biggest mistake is therefore doing nothing and letting the money sit uninteresting on the account," advises Müller.
However, even the eighth wonder of the world cannot prevent this: Normal interest-bearing investments like on a checking or savings account often do not suffice to keep up with inflation. She therefore recommends investing in stocks, which offer a chance for higher yields.
In the context of financial investments, Albert Einstein referred to compound interest as a significant factor. This mathematical effect, often underestimated, can help your wealth grow faster by earning interest on both the initial principal and the interest earned over time. This concept is particularly important in savings and investing situations.
compound interest can be utilized in various investment vehicles, such as ETFs, Index funds, or Stock tips provided by financial advisors. For instance, if you invest in an ETF with a compounding interest rate, your initial investment will earn interest not only on the initial amount but also on the interest earned throughout the investment period, resulting in higher returns over time.
Banks often offer fixed deposit accounts with compound interest rates, which can exponentially increase your savings over time. By reinvesting the interest earned, your money earns more interest each passing year, leading to substantial growth in your assets.
Private pension provision and retirement provision can be significantly boosted with the help of compound interest. For instance, if a 50-year-old invests a certain amount of money with a compound interest rate, they can expect a substantial return by the time they retire, ensuring a comfortable retirement provision.
Even though time is crucial for the compound interest effect, it works equally well for small investments. For example, an individual with limited savings can still benefit from this effect by regularly investing small amounts of money and reinvesting the interest earned.
When considering investments with compound interest, it's essential to consider the associated costs, such as management fees and transaction costs, as these can lower your overall returns. Investors should thoroughly research and compare the fees associated with various investment options to maximize their earnings.
