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Created on 29.05.2019 | Updated on 20.01.2021

Get more from your capital: compound interest and the compound interest effect explained in simple terms

Any investor will inevitably come across the compound interest effect, and it is a very good idea to get to grips with it. This is an effect that has a positive impact on how your fixed assets perform. It can boost returns on interest and compound interest generated from an investment quite significantly in the long term, which is why it is so important investors understand exactly what it’s all about and how to benefit from it.

The compound interest effect can explain how little sums become big sums quicker than expected. Indeed, it can even be worth investing small sums in an investment fund. This means you’ll have the prospect of returns that are significantly higher than the interest on a savings account — and you’ll benefit from the compound interest effect as well.

Compound interest ensures that the amount saved or invested as initial capital, as well as monthly or annual investments, increase at a disproportionately high rate. This compound interest effect is based on the principle that the longer the term of a financial investment, the stronger it gets. This may all sound complicated, but it is in fact a very simple principle. If you re-invest interest (or returns) from an investment, you will accrue further interest/returns. The longer you spend investing these returns based on this principle, the greater the compound interest effect. Still sound complicated? Watch how passers-by in the street reacted when we asked them to explain compound interest.

Compound interest: interest on re-invested interest

The easiest way to explain and calculate compound interest is by way of an example: a 35-year-old who invests CHF 200 per month over 30 years at an interest rate of 4% will end up with a total of just under CHF 140,000 by the time they reach 65. If the saving plan was started when that person was 25, he or she would receive almost CHF 100,000 more capital, having paid in only an additional CHF 24,000. The ten extra years of saving create extra interest of around CHF 70,000.

Want to calculate how much interest you could make on your own investments? This formula will help you calculate compound interest on a one-off payment:

Compound interest formula: P'=P*(1+r/100)nt

Apply the compound interest formula to our first example and you end up with: CHF 7,292.55 = 6,800*(1 + 0.02/100)35

Things get a bit more complicated if you also want to add extra monthly payments. To avoid grappling with formulas and calculations, use an online compound interest calculator or our investment calculator to assist you. This will help you calculate your financial objectives.

The compound interest effect: those who earn interest on interest can make disproportionate returns

This phenomenon, i.e. where the return on your investments increases at a disproportionate rate if you use compound interest, is known as the “compound interest effect”. It is especially relevant if you are looking to invest for a particularly long period of time, and if you want to keep re-investing the returns you make. In other words, a longer saving period increases profits. Of course, the opposite is also true, so the shorter the saving period, the shorter-lasting the compound interest effect. If a 45-year-old has 20 years left to build up his capital before retirement, he will end up with only a third of the final capital of a 25-year-old with the same savings rate. To achieve the same savings assets at the same interest rate, the 45-year-old would have to set aside more than three times as much every month, almost CHF 650. So a long-term strategy pays off: those who start investing earlier can make compound interest work better for them and increase the capital they invested more successfully. You can read why it is particularly worthwhile to invest at a young age in the article “Start investing when you’re young”.

Comparing products pays off — particularly in a low interest rate environment

Currently, interest rates on savings accounts are low, but this is the perfect time to consider alternatives such as investment funds with better potential returns. With an investment fund, you can also benefit from the compound interest effect in the long term. The easiest way to do this is with funds that re-invest their returns directly back into fund assets, i.e. accumulating funds. You can actually re-invest these returns yourself with distribution funds. If you decide to invest in an investment fund rather than save up, and you have a long investment horizon in mind, you will get a lot more for your money thanks to the compound interest effect. What do the terms interest, return and dividend actually mean? Find out in the article “Interest, dividends and returns”.

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