Q

What is compound interest?

A

It's the process by which the money you make on your principal investment itself becomes part of the principle for further investment.

To radically oversimplify it, you can think of compound interest as “interest on interest.” Whereas “simple interest” will only provide interest on your initial deposit, or “principal balance,” compound interest will provide interest on a principal balance plus any interest that has accrued in the account. For instance, if two years ago, you made a $10,000 deposit in an account offering a 5% annual percentage rate of interest, at the end of the first year, your account balance will be $10,500. In the second year, you will earn interest not only on your $10,000 initial investment, but also on the $500 interest you earned.

The way that institutions figure out how much interest you’re entitled to is through what’s known as “compounding periods.” These are the regular periods at which a snapshot of the account balance is taken in order to calculate how much interest you are owed; the more compounding periods per year offered in an account, the more compound interest you’ll make. Compounding also radically accelerates the growth of investments in equities if you reinvest all your capital gains (i.e. investment growth) as well as dividends back into your investment fund. For good reason, it’s been called “the miracle of compounding.” If a person invested $1,000 in Microsoft in 1987, thanks to compounding (and Bill Gates) they’d now be the proud owners of about $550,000 in Microsoft stock. Ta da. That’s compounding.

Wealthsimple is investing on autopilot

Get started in just 5 minutes, and your first £5,000 is managed free.

Learn more