Which investor does not dream of having their money work for them and having a steadily growing balance? When compound interest kicks in, that dream can come true. However, certain conditions must be met for this. In this article, you will learn what the compound interest effect is, how it works with different types of investments such as ETFs and stocks, and what factors influence it. We will also explain how you can calculate compound interest yourself using a simple formula.
What is the compound interest effect?
Compound interest is interest paid on interest income. With compound interest, it is assumed that the income will be reinvested over a longer period of time together with the initial capital at the same interest rate. The interest earned is not spent, but reinvested or accumulated – the capital to be paid increases. This effect occurs faster and faster over time, so that in the long term the compound interest effect means that the invested capital increases more steeply than with simple interest. In contrast to simple interest, the value of the money invested does not increase linearly with compound interest, but exponentially.
GOOD TO KNOW: Short interest periods such as a monthly or quarterly interest payment increase the compound interest effect. This is because the interest is taken into account more frequently in the current interest.
When does the compound interest effect apply?
In addition to the investment period and the amount of the initial capital, the interest rate also plays a decisive role in how much the compound interest effect unfolds. The above calculation example assumes a comparatively high interest rate of 5%. Because the compound interest effect only unfolds its full effect when the interest rate is high enough. Assuming an interest rate of 1%, the initial capital of 10,000 would rise to just 12,201.90 dollars after 20 years – despite the compound interest effect. In view of the current low interest rates on overnight money accounts and savings books, the compound interest effect on these products is hardly noticeable today.
Which factors influence the compound interest effect?
Using the example calculation above, the two factors that have a significant impact on the compound interest effect can be derived: time and money. If the compound interest effect takes effect, the sooner you start saving and the longer you invest your money, the higher your return will be. The same applies to the amount of capital invested: the more money you invest, the higher the increase in value if you continuously reinvest the interest income at a constant interest rate. However, unforeseen events such as economic crashes or financial scandals can also influence the compound interest effect.
How does the compound interest effect work with ETFs?
You can achieve a kind of compound interest effect with an investment in exchange-traded index funds or ETFs for short. An accumulating fund is ideal here . Because with such a product, the income is automatically reinvested. If you make a profit with your investment, your capital will increase steadily so that you have the opportunity to achieve an even higher return in the long term.
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Like all asset classes, exchange-traded index funds are also subject to market, industry and company-related fluctuations in value. Therefore, there will be no guarantee that you will increase your wealth in the long term with this form of investment – in fact, there is also a considerable risk of loss with this asset class. A constant “interest rate” as it is assumed for compound interest – or in this case a steady return – cannot be guaranteed in view of the unavoidable volatility on the financial markets. In addition, there are fees for investing in ETFs – for example in the form of an ETF savings plan – which reduce the performance, even if these running costs are mostly only between 0.2 and 05.%.
How does the compound interest effect work on stocks?
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No interest is paid on shares, but many companies give their investors a share of the profits they earn with an annual dividend distribution. In order to benefit from a kind of compound interest effect even with stocks, you can reinvest the dividend – manually for individual stocks or by selecting an accumulating fund that automatically re-invests such income for equity funds. Apart from the considerable risk of loss associated with every form of security investment, constant performance is not to be expected, even with stocks or equity funds. On the one hand, the companies set their own profit sharing year after year. The dividend can rise, but also fall – or even fail completely. On the other hand, the return on such a financial investment depends not only on the regularity and amount of the amount to be distributed, but also on the performance of the share. Finally, if the securities are sold for the purpose of realizing profit, flat tax including church tax may be incurred in addition to the fees.