Financial Terms Glossary
The most important financial terms - with simple and concise explanations.
Compound interest
Compound interest is the interest that investors receive on the interest earned on their securities. The compound interest effect is an important concept in investing money, because compound interest can cause assets to grow exponentially, provided that the returns achieved in each investment period are not withdrawn from the investment but continue to be invested in the following investment period. Since the new investment amount for the following period does not only consist of the original investment amount, but has been increased by the interest/returns already achieved, higher interest/returns can be realised in absolute terms in the following period.
Example: An initial investment of 10,000 Euros generates an annual return of 5 percent, resulting in an investment value of 10,500 Euros at the end of the first year. At the end of the second year, the investment rises to 11,025 Euros, at the end of the third year to a total of 11,576.25 Euros. If one had deducted the annual return from the portfolio in each case and reinvested only the original amount, one would have earned a total of only 11,500 Euros, i.e. 76.25 Euros less. After 30 years, the difference rises to 18,219.42 Euros, because with compound interest you would have earned 43,219.42 Euros, whereas without reinvesting the interest you would have earned only 25,000 Euros.