Business Analysis and Compound Interest.

The great Albert Einstein once said: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Successful businesses don’t just make money but the know how to compound what they have made. According to Ed Slott, publisher of IRAHelp.com was quoted to say “The greatest money-making asset anyone can possess is time.” investing is a long-term play and one must not sacrifice time. Rather one can take advantage of the compounding effect over time.

Overview

Compound interest (or compounding interest) is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from the previous periods. Thought to have originated in 17th-century Italy, compound interest can be thought of as “interest earned on interest,” and will make a sum grow at a faster rate relative to the simple interest, which is calculated only on the principal amount.

The Effect of Compounding Period

The rate at which compound interest accrues depends on the frequency of compounding, such that the higher the number of compounding periods, the greater the compound interest. Thus, the amount of compound interest accrued on $100 compounded at 10% annually will be lower than that on $100 compounded at 5% semi-annually over the same period. Since the interest-on-interest effect can generate increasingly positive returns based on the initial principal amount, it has sometimes been referred to as the “miracle of compound interest.”

After five years, the total amount would be $1,280.08. However, the amount at maturity would have been $1,250.00 for a simple interest computation.

Pros and Cons of Compounding

While the magic of compounding has led to the apocryphal story of Albert Einstein calling it the eighth wonder of the world or man’s greatest invention, compounding can also work against consumers who have loans that carry very high interest rates, such as credit card debt. A credit card balance of $20,000 carried at an interest rate of 20% compounded monthly would result in a total compound interest of $4,388 over one year or about $365 per month.

On the positive side, the magic of compounding can work to your advantage when it comes to your investments and can be a potent factor in wealth creation. Exponential growth from compounding interest is also important in mitigating wealth-eroding factors, like rises in the cost of living, inflation, and reduction of purchasing power.

Investments like Fixed deposits, money market mutual funds offer ways for investors to reap the benefits of compound interest. Opting to reinvest dividends derived from the mutual fund results in purchasing more shares of the fund. More compound interest accumulates over time, and the cycle of purchasing more shares will continue to help the investment in the fund grow in value. With a compound interest investment, you’re earning interest on top of interest, which means the return on your investment will grow faster over time. According to Charles Schwab, compound interest is a means for profit growth if used wisely. It works as a return multiplier, and with each passing year, the interest that investors receive grows because they earn interest on interest.