Compound interest refers to interest that is calculated based on the original principle plus the interest that has been earned and accumulated by the principle.
In layman terms, this is the technical jargon for interest on interest.
Many famous investors attribute the magic of compounding as a central reason behind how they managed to accumulate great wealth.
Like all things economics, there are two sides to the discussion of compound interest.
Consumers and investors regularly seek investment opportunities where their earnings can be compounded.
Lenders on the other hand would like no better than to charge borrowers compounded interest on their credit facilities.
Dynamics of compounding interest
It is important to keep in mind that the more frequent a facility is allowed to compound, the greater the benefits would be for the earning party.
For example, if $1,000 is to compound at 10% once a year, then it would become $1,100 at the end of the first year, and $1,210 at the end of the second year. The multiplier effects can be quite impactful when annual compound frequency is taken into account as illustrated in the below table.
|$1,000 at 10%
|End of first year||$1,100||$1,210||$1,461.10|
|End of second year||$1,210||$1,461.10||$2,143.59|
|End of third year||$1,331||$1,771.56||$3,138.43|
When we look at the original amount of $1,000 and compare it with the quarterly compounding effect leading to $3,138 at the end of the third year, it can be easily observed that the $1,000 has grown to more than 3 times it’s original size.
All these just from an interest rate of 10%.
The implications of the power of compound frequency also means that an investment that yields 5% but has a mechanism that allows it to compound twice a year would be more profitable than one that yields 10% but only compounds once a year.
Common applications of compounding interest
While equity investors would like to see their dividends collected from stocks or mutual funds be put back into more stocks and funds so as to compound their earnings, this is not always possible due to the unpredictability of stock price fluctuations and CEO agenda.
So the most common investment vehicles that regular investors and consumers turn to for exploiting compounding interest are with cumulative fixed deposits.
These are time deposits that earn an attractive interest considerably higher that regular savings accounts. Interest earned are automatically deposited into the same account, effectively increasing it’s principle deposit. The following interest calculation period would then be based on the new increased principle.
But as with any business, when there is a winner, there will be a loser on the other side.
Banks that don’t want to be taken advantage of by consumers this way often counter this savers behavior by introducing non-cumulative fixed deposits instead.
Such accounts would make a payment to deposits when interest is due. Often by cheque.
The consumer would not be able to deposit that money into the FD account as the principle is fixed.
If consumers want to earned interest on the interest earned, they would have to open a new fixed deposit account with a minimum deposit in order to enjoy the attractive interest rates.
This makes it difficult for savers with no extra cash to spare to open multiple FD accounts to earn an interest on interest.
But banks don’t just have a defensive strategy against compounding interest, they have an attacking strategy too.
One of the biggest revenue generators for banks are with credit cards.
Lenders and credit card issuers implement compounding Interest rates on their cards when calculating interest charges to cardholders.
This means that any outstanding balance that is rolled over at the end of the payment period would incur it’s own interest as well… and this can compound on a daily basis.
This is why it is so easy for people to get into huge credit card debts.
And it could also be a reason why card issuers often highlight the minimum payment amount in credit card statements.
Maybe they are quietly wishing that consumers would only pay the minimum amount. Thus leaving outstanding balances which they can compound with interest charges.