For savers, the compound interest effect is an important component in building up their wealth. We want to explain why this is so in this article.
- Compound interest leads to above-average returns on investments.
- The interest earned in a billing period is added to the capital to be paid interest.
What does compound interest mean?
Short for COI by abbreviationfinder, the compound interest describes the interest paid on the interest . That sounds a bit complicated now, the following example should clarify the situation:
Two savers invest 1,000 euros at an interest rate of five percent per year for a period of two years. Saver number one has the accrued interest of 50 euros paid out after one year , saver number two leaves it in the account . In the second year, interest is paid on these 50 euros. At the end of the term after two years, he will receive EUR 1,102.50. Saver number one is credited twice with 50 euros each, so has a lower return .
How does the compound interest effect exactly?
What is only a marginal note in this calculation example, reaches a completely different dimension with a financial investment over 20 years with 20,000 euros one-time investment and only three percent interest.
In the case of annual interest payments, the final capital is 32,000 euros. With an interest-bearing accumulation of the distribution, however, the final capital amounts to 36,122.22 euros.
Investors who prefer mutual funds usually have a choice between distributing funds and accumulating funds. The latter automatically reinvest the distributions. This also leads to a significant increase in the return .
Calculate compound interest with formula
Fortunately, there are enough options on the Internet to determine compound interest. Nevertheless, one or the other may be interested in the formula on which the calculation of compound interest is based:
- K_new = K * (1 + p / 100) to the power of n.
The question naturally arises as to what is hidden behind the abbreviations.
K_new stands for the final capital after the interest has been credited . K denotes the initial capital without interest. P represents the placeholder for the interest rate and n the number of years .
Applied to our calculation example for 20,000 euros and a duration of 20 years, the determination of the final capital would read as follows:
K_new = 20,000 * (1+ 3/100) to the power of 20.
If you only know the final capital and would like to know how high the initial capital was, use the following formula:
- K = K_new / ((1 + p / 100) to the power of n)
For our example above, the calculation method is as follows:
K = 36,122.22 / ((1+ 3/100) to the power of 20).
The compound interest in everyday life
Savers who invest their money in a savings book or a call money account automatically benefit from compound interest, provided they do not withdraw the credited interest on January 2nd. Fixed-term deposits that run for more than a year also automatically offer compound interest. Accounts that automatically pay out the interest are rather exotic.
Savings plans for capital-building benefits and building society contracts are also considered classics for the compound interest effect. The same also applies to life insurances , which today, unlike in previous years, no longer distribute profits annually, but instead add them to the end of the term cumulatively.
Compound Interest in Politics
What is right for investors to increase their returns can only be cheap for politicians as debtors. As early as 1776, the compound interest effect came into play in England as a means of reducing national debt.
A share capital was paid into a so-called redemption fund. This capital was topped up through the addition of saved interest through repayments of government debt that had already been made. The aim was to use the interest saved and the compound interest effect on the initial capital and the interest subsidies to achieve a final capital that was sufficient to repay the national debt in one sum.
The taxation of compound interest
Since the local banks automatically pay the final withholding tax on income paid, the interest credits are also taxed automatically. However, there is no taxation if you, as an investor, submit an exemption application. This provides for tax exemption for investment income of up to 801 euros per year for single people and 1,602 euros per year for married people.