Interest received every year = interest from principal invested
Compounded interest is interest earned on the principal where interest received will be reinvested. The interest amount receive every year will equal to interest rate times principal and the interest received from reinvested interest.
Interest received every year =
interest from principal invested + interest from reinvested interest
The interest earned on interest provides the first glimpse of the phenomenon known as compounding.
Illustration below shows the different in future value for simple interest versus compounding interest base on initial investment of $1,000 and annual interest rate of 10%.
Although interest earned on the initial investment is important, for a given interest rate it is fixed in size from period to period. The compounded interest earned on reinvestment interest is a far more powerful force, because for a given interest rate, it grows in size each period.
Illustration below shows the power of compounding. For an initial investment of $1,000 which grows at 10% annually for 30 years, the value with compounding interest will grow to 4.36 times in value as compare to simple interest.
The important of compounding increases with the magnitude of the interest rate. As interest rate increases, the compounded interest earned on reinvestment interest will grow at higher speed.
Table below illustrate investment value after 30 years for 5 scenarios , with compounded rate increases at 5% for each scenarios . With $1,000 invested for 30 years, future value increases by 3 – 4 times for every 5% increases in interest rate.
For an investor with limited investment funds, ability to master financial and investment knowledge is essential to increase compounded rate to grow the initial investment more rapidly.
As illustrated below, an investor who is capable of generating 25% compounded grow annually will receive $807,794 by end of 30 years with an initial investment of $1,000 as compare to investor with 5% compounded grow annually, will only receive $4,322.
Table below illustrate investment value after 30 years for 5 scenarios , with compounded rate increases at 5% for each scenarios . With $1,000 invested for 30 years, future value increases by 3 – 4 times for every 5% increases in interest rate.
For an investor with limited investment funds, ability to master financial and investment knowledge is essential to increase compounded rate to grow the initial investment more rapidly.
As illustrated below, an investor who is capable of generating 25% compounded grow annually will receive $807,794 by end of 30 years with an initial investment of $1,000 as compare to investor with 5% compounded grow annually, will only receive $4,322.
Investment return of187 times higher, which can only achieve through discipline investment strategy and mastering financial & investment knowhow and skills.
Frequency of compounding
Frequency of interest compounded over time will determine the final value of investment. As frequency of compounding increases, all else equal, the higher the future value.
For instant, many banks offer daily compounded interest rate for both saving and mortgage. This feature of higher compounded frequency will increase the effective interest rate for saving while reduces interest expenses when principal is paid to bring down the mortgage outstanding.
Higher frequency of compounding also reduces the gap between interest rate on one month certificate of deposit as compare to one year certificate of deposit. By assuming annual interest rate compounded annually for certificate of deposit is 3.5% while annual interest rate compounded monthly for certificate deposit is 3%, effective annual interest rate for monthly compounding will be 3.03%. Thus, the gap difference is 0.47% instead of 0.5% when compare the interest rate directly.
Table below illustrate the effect of frequency of compounding to an initial investment of $1,000 for 30 years.
Frequency of interest compounded over time will determine the final value of investment. As frequency of compounding increases, all else equal, the higher the future value.
For instant, many banks offer daily compounded interest rate for both saving and mortgage. This feature of higher compounded frequency will increase the effective interest rate for saving while reduces interest expenses when principal is paid to bring down the mortgage outstanding.
Higher frequency of compounding also reduces the gap between interest rate on one month certificate of deposit as compare to one year certificate of deposit. By assuming annual interest rate compounded annually for certificate of deposit is 3.5% while annual interest rate compounded monthly for certificate deposit is 3%, effective annual interest rate for monthly compounding will be 3.03%. Thus, the gap difference is 0.47% instead of 0.5% when compare the interest rate directly.
Table below illustrate the effect of frequency of compounding to an initial investment of $1,000 for 30 years.
In summary , the higher the compounded interest rate and frequency of compounding , all else equal, future value of an investment today will grow more aggressively.
Investment knowhow and discipline investment strategy is the key factors towards the success.
Investment knowhow and discipline investment strategy is the key factors towards the success.
