Obviously, you know what an interest rate is. If you borrow $1000 from your fiend for one year and they agree to charge you an interest rate of 10% (the crook!), it means that at the end of the year, you will repay them $1100. Until now it’s easy, right?
To invest effectively, you must also know how compound interest works. Here’s a simple example. Your friend agrees to lend you $1000 over a period of 5 years. The interest rate is still 10% per year, but this time it’s calculated with compound interest. With simple interest, calculating what you will owe after 5 years is easy:
You will need to pay them 10% of the amount borrowed per year, which is $100 per year. After 5 years, you will then owe your friend $1500 ($1000 + ($100 x 5)). With compound interest, it’s a little more complicated – the rate applies not only to the amount borrowed, but also to the amount borrowed plus any accumulated interest.
So after the first year, because there is not yet any interested accumulated, it will be 10% of $1000, which is $100. However after the second year, the interest will be 10% de $1100 (the initial $1000 + $100), which is $110 (1100 x 10%). After the third year, it will be 10% of $1210 ($1000 + $100 + $110), which is $121, and so forth until the end of the 5-year term, after which you must pay your “friend” $1610.50.
In the stock market you’ll often hear about compound interest or compound return. So when you hear that an ETF has a return of 7% per year, don’t think that this is “ridiculous” because a 7% return compounded for 25 years on $1000 means that you will pocket $5427 at the end of the term. One last important thing to know about compound interest is the period for which the interest is calculated. As a general rule, it is calculated yearly, but sometimes it can be calculated monthly. The shorter this period, the faster the interest will climb.
Go back to the encyclopedia index