08 Oct Understanding Investments: The Power of Compound Interest
“Compound interest is the eighth wonder of the world. He who understands wins, he who does not understand loses “– Albert Einstein
What is Compound Interest?
Compound interest is undoubtedly one of the most powerful forces in financial markets. When calculating interest rates on loans, deposits or investments we may be dealing with simple interest or compound interest.
To understand compound interest, we must first clarify the concept of simple interest. Simple interest is calculated only on the principal amount. For example, you invest 1,000,000 Lekë in a bank deposit with an interest 3% per year, for 2 years. What will be the value of your investment after 2 years? The answer is 1,060,000 Lekë and the interest earned will be 60,000 Lekë. The calculation is simple.
In the case of compound interest, the principal in each period is different. The interest earned will be added to the value of the principal. The compound interest is calculated on the principal and on the interest accumulated in the previous periods, so you gain interest upon interest.
In our example, in addition to the principal of 1,000,000 Lekë, the interest earned in the first year of 30,000 Lekë will also earn interest next year. So, how much will your deposit of 1,000,000 Lekë be worth after 2 years with an annual interest rate of 3%? The answer is 1,060,900 Lekë and the interest earned will be 60,900 Lekë.
Key element: Time
The true power of compound interest is best demonstrated in long-term investment periods. Time is in fact the key element that makes compound interest work better. The time when you start investing is more important than the amount of investment and we can show this quite simply by the following illustration: