Category: Investing

How Compound interest  works to grow wealth?

My wealth has come from a combination of living in America, some lucky genes, and compound interest“

– Warren Buffett

Compound interest means interest on interest. It is the result of reinvesting interest, rather than taking it out.

To understand the concept, let us assume $10,000 is invested @ 5% interest which is withdrawn at the end of each year. Total simple interest earned will be $ 1500 at the end of 3 years

YearPrincipalInterest @ 5% p.a.
110,000500
210,000500
310,000500
Total interest1500
Table 1: Simple interest

Let us assume $10,000 is invested @ 5% interest which is reinvested at the end of each year. This means at the end of year 1, interest earned $ 500 will be added to $ 10,000 principal and interest will be calculated for year 2 on $ 10,500 amounting to $ 525. Total cumulative interest earned will be $ 1576 at the end of 3 years

YearPrincipalInterest @ 5% p.a.
110,000500
210,500 (10000+500)525
311025 (10500+525)551
Total interest 1576
Table 2: Compound interest

We can see that compound interest results in interest of $1576 at the end of 3 years compared to simple interest of $ 1500, i.e. an extra interest of $ 76 by just keeping interest reinvested.

One can see, how power of compounding can help grow your wealth much faster.

Rule of 72

The rule of 72 is used as rule of thumb for estimating an investment’s doubling time.

The formula of Rule of 72 is

T  =  72/r

Where

r  = rate of interest / year

T = number of periods required to double an investment’s value

For example, we want to know what is the time required to double investment @ 6% rate of interest.

It will take 12 years ( T = 72 / 6) to double the interest.

So, next time someone asks you to tell how much time an investment at a certain rate of interest takes to double your money, use of Rule of 72 can be a quick handy tool and you do not need our calculator or laptop.

It may be noted that Rule of 72 & other variations i.e. the rule of 70 and the rule of 69.3 gives approximate time an investment takes to double the investment.