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Created on 29.05.2019

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 seeing as it is an effect that can have a positive impact on how your investment 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. For one thing, you would have better prospects of making a return than with a savings account, and then you have the compound interest rate itself.

Compound interest ensures that the amount saved increases 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? Let’s see how the people we asked about compound interest on the street fared.

Compound interest: interest on re-invested interest

The easiest way to explain compound interest is using an example: a 35-year-old who invests CHF 200 a month at 4% over 30 years will have pension fund assets of almost CHF 140,000 by the time he or she reaches 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 know 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

This would be the calculation for our first example: 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. This is where our investment calculator will come in handy for you. This will help you calculate your financial objectives.

The compound interest effect: the longer the period, the greater the effect.

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 only 20  years to build up his capital, with the same saving rate he will end up with only a third of the final capital of a 25-year-old. To achieve the same savings assets, the 45-year-old would have to set aside more than three times as much every month, almost CHF 650. This means that investors who start saving earlier can make compound interest work better for them and increase their capital more successfully.

Comparing products pays off

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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