In this blog, we’ll share all the main principles of compound interest growth, how it works, the formula behind it, and the benefits of this investment strategy.
What is compound growth?
Compound growth is when your money grows as you reinvest your interest. In other words, it’s the growth upon the growth of your capital.
Rather than cashing out your return, you reinvest any interest you accumulated and earn even higher returns over multiple periods of time. These small increases in growth can make a massive difference over extended periods of time.
How does compound growth work?
The main principle behind compound growth is to boost your savings and make your money work harder for you, which helps you reach your financial goals more efficiently.
When the interest you earn is reinvested through compound growth, your savings essentially begin to experience a snowball effect, as any interest earns further interest and so on.
Let’s take a look at the effect of the compound growth formula in action. We’ll examine how a difference of 1% in your investment return rate over the years can make an almost 40% difference in your final capital.
Imagine two 20-year-olds, Mario and Luigi, begin to invest a monthly contribution of £56, every month, until they reach the age of 65. Mario receives a rate of 6% on his money whereas Luigi receives 7% of his savings.
Although there is only a 1% difference in the amount that is reinvested through the compound growth rate, the final results are striking.
Mario: Paying £56 per month until age 65 at a rate of 6% = Fund of £153,000
Luigi: paying £56 per month until age 65 at a rate of 7% = Fund of £212,000
That’s a whopping 39% difference - all from a 1% difference in the rate of return! It just shows how much of a difference a couple of per cent can make in the long term.
What is the compound growth formula?
To work out the compound interest formula, you’ll need to know your initial principle balance (P), the interest rate (r), the number of times your interest has been applied per time period (n), as well as the number of time periods elapsed (t).
Compound Interest or CI = P(1 + r/100)n - P.
To calculate the compound annual growth rate formula (CAGR) of an investment, you’ll need to know the beginning value (BV) and the ending value (EV) of your investment, as well as the number of years (n).
CAGR = (EV/BV) ^ (1/N) – 1.
The compound annual growth rate formula helps investors come up with a representational figure. It’s purely representational because it illustrates the rate at which your investment would have grown if it were to grow at the same rate year upon year with all profits being reinvested.
If you're not the greatest mathematician, or you can’t get your head around the compound growth rate equation, why not use our compound growth calculator instead?
This free online tool can help determine your future investment amount by determining the effect compound interest has on your savings.
Benefits of compound growth
By far, the greatest advantage of the compound growth factor is that minor investments can turn into major returns. As we saw with our previous example, a small difference in return rates, as little as 1%, can yield impressive profits.
This snowballing effect that the compound annual growth rate formula has on your savings can also work to battle the effect of inflation.
As the years go by, your purchasing power decreases due to inflation. The compound growth rate ensures exponential growth over prolonged periods of time.
All investments are subjected to fluctuations in the market. However, compound interest can help facilitate steady growth. A small percentage each year can make a world of difference when it comes to compound interest.