Albert Einstein is here to present lesson five in our BUX homeschooling series. Don’t worry, this isn’t a lesson about quantum mechanics or the theory of relativity. It’s a phenomenon that fascinated even Einstein: earning interest on your interest.
Einstein even called it the 8th wonder of the world. Interest on interest, also known as return-on-return or compound interest, is a way to make your money work for you. And we all want that, right?
This effect is best explained with a very simple example.
Suppose you invest €1,000 every year and you get a 5% return annually. After the first year you’ll have €1,050. So far, so simple.
In the second year you put in another €1,000 and at the end of that year you will receive another 5% return.
Let’s do some quick maths. That’s 5% on €2,050 = €102.50. And that puts you at a total of €2,152.50 after the two years.
In other words, you’re making €100 interest on the€ 2000 you deposited. But you’re also making €2.50 on the interest from your first year. It’s interest on interest, without doing anything else at all.
Now,€ 2.50 doesn’t sound like much. But don’t forget that this effect continues to grow year after year. So the third year looks like this:
€2,152.50 + new €1,000 investment = €3,152.50 + 5% interest = €157.62 for a total of €3,310.12
At the end of the third year, this €157.62 consists of €150 interest on your own invested money and €7.62 of compound interest. So this effect has tripled after a year!
Keep doing this for a few more years and you’ll see what wonderful interest-on-interest can lead to.
This is a simple example, of course. It doesn’t take into account fluctuating returns or different deposit amounts. But this phenomenon gets really exciting if you keep doing it for a long time, say 20 years or longer, without withdrawing money in the meantime.
‘‘All views, opinions, and analyses in this article should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.’’