Compound interest is a fundamental concept in finance and investing. It plays a crucial role in the growth of savings over time. Have you heard of compound interest? How does it work? How is it calculated? All the explanations.
Definition of compound interest
Compound interest is based on the idea that the interest earned on an investment is reinvested, generating additional interest in subsequent periods. This process can occur annually, semi-annually, quarterly, monthly, or even daily. The higher the compounding frequency, the faster the capital growth.
How is compound interest calculated?
The compound interest formula is used to calculate the future amount of an investment after a certain period of time.
Let’s take a detailed example to illustrate the calculation of compound interest:
- Principal initial: 1000 euros ;
- Annual interest rate: 5%;
- Frequency of composition: quarterly;
- Investment duration: 5 years.
After 5 years, the investment of 1000 euros will be worth approximately 1282 euros (1000(1+0.05/4​)^4X5).
What are the differences from simple interest?
Unlike compound interest, simple interest is calculated only on the initial principal of an investment or loan. It does not take into account interest accrued over time.
For example, if you invest 1000 euros at an annual interest rate of 5% for 3 years, you will receive 150 euros at the end of this period, for a total amount of 1150 euros.
Why prefer compound interest?
Compound interest is often preferred by investors. This is due to the benefits it provides:
Exponential growth
With compound interest, investments grow exponentially rather than linearly. Each period, interest is calculated on the initial capital as well as on the accumulated interest from previous periods. Thus, as time passes, the base on which interest is calculated increases. For example, if you invest 1000 euros at a compound interest rate of 5% per year for 20 years, you will earn much more than with simple interest.
Long-term profitability
Compound interest is particularly useful for financing long-term projects (preparing for retirement, financing a trip, or purchasing real estate).
An incentive to reinvest
Compound interest encourages the reinvestment of earnings. Instead of withdrawing the interest earned, investors are encouraged to leave it in the account, thereby increasing the capital on which future interest will be calculated. For example, by reinvesting stock dividends rather than withdrawing them, you increase the number of shares held, leading to even higher dividends in the future.
Effective financial planning
This investment method facilitates planning and allows you to project the growth of your investments over the long term. Thanks to compounding, small, regular investments can grow significantly.
Better protection against inflation
Compound interest offers better protection against inflation than simple interest. As rising prices erode household purchasing power, investments with compound interest can grow at a rate exceeding inflation, preserving the real value of money. Therefore, opting for compound interest is a wise strategy to maximize the growth of your investments and savings over the long term.
The Disadvantages of Compound Interest
Despite its advantages, compound interest also has its drawbacks, starting with the complexity of its calculation method. Indeed, projections often require detailed calculations or the use of specialized financial tools.
Second, while compounding frequency can increase returns, it can make investment management more difficult. Therefore, it is important to understand how it affects interest and ensure that the calculations accurately reflect investment reality. Management fees can significantly reduce the benefits of compound interest. For example, an investment account with a high annual management fee will affect the earnings, reducing the impact of this calculation formula. The idea behind compound interest is to reinvest earnings. However, if these earnings are reinvested in risky assets, there is a risk of capital loss that can reduce or even cancel out the benefits of compound interest. Finally, the benefits of compound interest are maximized over long periods of time, meaning investors must be prepared to lock up their money for extended periods. This can be a problem for those who need short-term cash.
Which products should you choose to take full advantage of compound interest?
To take advantage of compound interest, you can turn to several investment products that allow you to reinvest the gains:
Savings accounts
Savings accounts offered by banks typically earn compound interest on the account balance. While they offer low risk and high liquidity, the associated interest rates are often low.
Investment funds
Investment funds include index funds, which allow dividends to be reinvested, and mutual funds (FCP), which allow the pooling of securities held by investors.
Dividend stocks
Investing in stocks of companies that pay regular dividends and choosing to reinvest them allows you to benefit from compound interest.
The obligations
Bonds are debt securities issued by entities to finance their projects. When an investor purchases a bond, they lend money to the issuer in exchange for regular interest payments or the repayment of the principal at maturity. There are several types of bonds: corporate bonds, sovereign bonds, quasi-government bonds, asset-backed securities, zero-coupon bonds, and emerging market bonds.
The retirement savings plan (PER)
Created by the PACTE law, the retirement savings plan is a wise choice. Open to all, it can be subscribed to with a financial institution or an insurance organization. In concrete terms, it allows you to save during your working life to receive a capital sum or an annuity upon retirement. The capital can be recovered early in the following cases: disability, death, expiration of unemployment benefit rights, over-indebtedness, cessation of self-employment following a liquidation order, or the purchase of a primary residence.
