Traditional finance will explain compound interest as the interest paid on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods. However, it is also the rate of return on an investment like a stock or real estate purchase.
When interest is compounded on an investment, the interest earned in one period is added to the principal, so that the interest earned in the next period is based on a larger amount. The more frequently interest is compounded, the greater the amount of interest earned over a given period of time. For example, if an investment earns an annual interest rate of 5%, the interest earned in the first year is $50 on a $1,000 deposit. If interest is compounded annually, the deposit will be worth $1,050 at the end of the first year. If interest is compounded semi-annually, the deposit will be worth $1,025 after six months and $1,051.25 after one year.
Historically, home ownership has produced around 5% a year while the S&P 500 has generated around 10%. Over time, that 5% difference per year adds up to an incredible advantage for stock ownership over home ownership. Let’s just use the average mortgage term of 30 years at 5%. Let’s just say you pay cash for your house and it costs $300,000. In 30 years, with the historic compound interest rate at 5% for real estate, that home appreciates to $1.3 million. Do the same investment amount at 10% for an investment in the S&P 500 and that asset appreciates to $5.2 million. The difference is stark and significant. Let’s say you get 20% a year… that investment now becomes $71 million. Let’s say you get 30% a year… that investment now becomes worth $785 million. You get it.
There are a few key factors to consider when calculating compound interest:
- Principal: The initial amount of money that is invested or borrowed.
- Interest rate (or) Rate of Return: The percentage of the principal that is charged as interest.
- Compounding frequency: How often the interest is added to the principal (e.g., annually, semi-annually, quarterly, monthly, daily, etc.).
- Time: The length of time over which the interest is calculated.
In conclusion, Compound interest is the interest on interest, it can grow the investment at an exponential rate and can be favorable for both borrowers and savers. The calculation of compound interest depends on the principal, Interest rate, compounding frequency and time. There are many online calculators available to help with the calculation.
