The power of compound interest

Posted on 09-09-2018 by F. Geurtsen

Albert Einstein called the power of compound interest the eighth Wonder of the World and Warren Buffett is living proof that reinvesting your returns can make you a great fortune. This article therefore explains the power of reinvesting your returns and illustrates it with some examples. 

“Compound interest is the eighth wonder of the world.” – Albert Einstein

Simple interest

Suppose you invest €10,000 in a proposition of Crowdrealestate. The fixed interest rate of this proposition is 5.0% per year and the term is five years. During the term you will receive €500 per year in interest and after five years you will be repaid. In total, you will then have made a 25.0% return on your €10,000 deposit.

Compound interest

When you reinvest your interest directly, interest is calculated not only on the deposit, but also on the interest credited. This is also known as interest-on-interest or compound interest. This gives you increasing returns over time.

In the first example, with an equivalent interest rate, after five years you will have made not 25.0% but 27.6% return on your deposit. If you reinvest the annual interest of €500 each time, you will receive as much as 21.6% more return on your deposit in the fifth year than with simple interest.

The power of reinvesting returns

With simple interest, your capital increases linearly. With compound interest, on the other hand, your assets do not increase linearly, but exponentially. A useful tool to estimate the effect of compound interest is the 72-rule. This rule indicates (approximately) how long it will take you to double your deposit. For example, at an interest rate of 5.0%, your deposit will have doubled after only 14.4 years (72 / 5 = 14.4). In comparison, with simple interest, it will only be after 20 years.

Compound interest therefore has maximum long-term effect. The power of compound interest only really manifests itself after years. So patience is a virtue.

Warren Buffett on compound interest