What Is Compound Interest and How to Grow Your Money

Simple vs. compound interest

With simple interest, interest is always calculated on the initial capital: €10,000 at 5% generates €500 every year. With compound interest, the previous year's interest is added to the capital and generates new interest: the second year it is calculated on €10,500, the third on €11,025, and so on.

The rule of 72

A practical rule: divide 72 by the annual interest rate to get approximately the number of years it takes for your money to double. At 6%, your investment doubles every 72/6 = 12 years. At 9%, every 8 years. This illustrates why even small differences in return have an enormous long-term impact.

The time effect: two investors

Investor A starts at 25 and contributes €200/month for 10 years (until 35), then stops. Investor B starts at 35 and contributes €200/month for 30 years. At 65, assuming 7% annual return, Investor A has more money despite having contributed three times less. Time in the market beats the amount contributed.

Compounding frequency

Monthly compounding produces more than annual compounding at the same nominal rate. A 6% rate compounded monthly is equivalent to an APR of 6.168%. For long-term investments in index funds, compounding is continuous and automatic as dividends are reinvested in the fund.

Inflation: the silent enemy

To calculate real return, you must subtract inflation. If your investment returns 7% but inflation is 3%, your real return is 4%. Over the long term, keeping money in a non-interest-bearing current account means losing purchasing power every year.