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How Does Compound Interest Work?

What exactly is multiplication of money? It is nothing but investing money in a tool or asset which gives you a chance to earn interest out of the money invested. As an investor, you have two choices. You can withdraw the interest component and use it on a periodical basis.

Alternately, you can let the interest remain along with the principal and reinvest the interest component too. When this continues for a period of time, you would certainly see our principal and interest growing into a sizeable wealth over a period of time. In this article, we will try and find out how compound interest has a role to play in creation of wealth.

What exactly is compound interest?

Compound interest is nothing but interest on interest. For example, if you invest $100 dollars with an annualized return of 3%. At the end of the particular year, you interest would be $3 which when added to your principal would make it $103 (100 plus 3). Again when this $103 is reinvested for a further period of one year or 360 days, your entire kitty at the end of the second year will be $109.18 the interest component for $106 for one year being $6.18. Hence when this continues for a period of time you will certainly find that your principal of $100 invested quite a few years back could yield rich dividends.

 Understanding Guaranteed Investment.

While the above is a general idea about compound interest, you must bear in mind that there are two types of investments, viz. guaranteed investments and non-guaranteed investment. In the guaranteed model, you will be assured of a minimum interest at the end of the tenor. It could be either 3.4% or something else as decided at the time of your entry into the scheme. Hence, for those who are looking for stable and secure returns on their investments, this certainly is a good way forward.

Non-Guaranteed Investment

On the other hand, non-guaranteed investment is an investment where there is no guaranteed or fixed investment, which is promised to the investor. It is totally determined by the market forces. For example an investment of $100 could fetch a return of $3, during the first year and your overall portfolio value could be $103, after the end of the first year. However, the second year may see the market interests coming down to 1% in which case your portfolio at the end of the second year could become $104.03, which again could go up or come significantly the third year and so on.

Which Option to Choose?

While guaranteed income options are better for those who are risk averse, for customers who are willing to stick their neck out and take some calculated risks, the second option would be not a bad idea.

How Does Compound Interest Work? was last modified: May 26th, 2014 by Tammy Richards

Author:

Entrepreneur, writer, and marketing expert. Would like to share my experience and knowledge with Australian business owners, especially small businesses, and new starters.

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