What is Compound Interest
Simply put, compound interest is the interest generated on a deposit that is then added to the principal sum to generate more interest.
This might be a difficult principle to understand, so let's take a look at an example. Pretend that you have a tomato garden with a total of 6 plants. Each plant only produces one tomato per year. Instead of taking the tomatoes and eating them, you decide to plant them. So, next year, you have 12 plants that produce 12 tomatoes. Again, you choose to plant them so your garden will have 24 tomato plants next year.
Compound interest works the same, but don't expect your investment to double in a year. Let's look at another example that's more close to reality. You deposit $100,000 in a savings account with a 1% p.a. After one year, the bank gives you $1,000, so now you have $101,100. Next year, your interest will increase to $1,010 and so on.
The Power of Compound Interest
Compound interest is a powerful tool that, over time, can help you generate wealth. This is what Warren Buffett had to say about it in June 2011: "My wealth has come from a combination of living in America, some lucky genes, and compound interest." If you don't know who Warren Buffett is, he's one of the richest men in the world, having built his wealth on the stock market. He started investing at the age of 11, and by the age of 21 his net worth was $20,000. It took him just 13 years to become a millionaire and another 21 to make a billion dollars. At the age of 91, his net worth is 115.6 billion USD.
Not many people can become as successful as him, but this doesn't mean you shouldn't invest.
Let's look at an example and see just how powerful compound interest is.
You're 21 years old, and you begin investing. Not much, just $100 per month, which you use to buy dividend stocks with an annual dividend of 4%. You continue to do this until you retire, so that's roughly 44 years.
Just by investing $100 each month, with the power of compound interest, by the age of 65 your investment would be worth $139,079. Your principal (the sum you invested) would be $52,900, and your interest $86,179.
That's not enough to retire comfortably, but what if you doubled your monthly investment? In that case, your investment would be worth almost $300,000 by the time you retire.
How to Calculate Compound Interest
To calculate the compound interest, you will need to use a rather complex formula:
A = P(1 + r/n)(nt)
A = final amount
r = interest rate (decimal)
n = how many times the interest rate is compounded per unit t
t = duration of investment
As you can see, this is a very complex formula, and unless you're a math whiz, you probably won't get it right the first time.
Instead, you should use our compound interest calculator, which will do all of these calculations for you instantly. All you have to do is select the initial investment, monthly contribution, duration, and estimated interest rate, and our calculator will do all the math for you.
Besides the final amount, our compound interest calculator will also show how much your investment will have grown each year.
Where Can You Use a Compound Interest Calculator
People use a compound interest calculator to calculate how much their investments will grow, whether it's a savings account or a dividend stock portfolio.