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What is Compound Interest and Why is it so Powerful?

Aktualisiert: 24. Aug. 2023

Why the "rich" are getting richer and richer....

It is important to understand that people with assets such as stocks, bonds or real estate generate returns that increase in value over time. When one reinvests these returns, the capital becomes larger and larger, and so does the potential return.

Let's consider a practical example: Let's say you have 10,000 euros and you invest it in an investment that yields 5% per year. After one year you have 10,500 euros. If you reinvest the entire amount including interest, you will have 11,025 euros at the end of the second year. In the third year it would be 11,576.25 euros and so on. This means that every year you earn a return not only on your original capital, but also on the income you have already earned. This is the compound interest effect, and it causes your wealth to grow faster and faster the longer you are invested.

Let's assume you invest 10,000 euros in shares that generate an average return of 8% per year. After 10 years you would have about 21,589 euros, after 20 years about 46,609 euros and after 30 years even 100,626 euros. If you let your capital work only 5 years longer, 35 instead of 30 years, you increase your fortune again by nearly 50% to approx. 147,853 euro.

This shows how powerful the compound interest effect can be. In this example, however, we have assumed that you invest 10,000 euros once and then never lift a finger again. So what happens if you invest an additional 400 Euros per month on top of your initial capital? Congratulations you are a millionaire! After 35 years you have a total wealth of about 1.010.816 Euro. The breathtaking thing is that you have only paid in 178,000 euros and the remaining 832,816 euros is interest or income on your invested capital.

The example above is of course highly simplified because important influencing factors such as taxes, inflation and transaction costs have not been taken into account here. However, it should make you aware of two things:

  1. It is absolutely within the realm of possibility to become a millionaire even if you were not born one.

  2. Time is the most important factor in your investment, so you should start as early as possible.

The gap between "poor" and "rich" is widening because "rich" people own assets that earn money for them, even if they don't work and lie on the beach or sit in a café reading a book. So if you don't own assets, you won't manage to achieve financial independence in the long run either, but more on that later....

Click here for the compound interest calculator:

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