The compound interest

What is compound interest?

Let’s start at the very beginning: what is compound interest. Compound interest is nothing more than when you do not take out the interest earned on the investment, but reinvest it, and then at the end of the period you also reinvest the growth achieved in the amount thus increased.

Do you understand the operation of compound interest?

9 out of 10 people say “Sure!”

If that were true, there would be no example of someone living month after month. Neither as a business nor as an individual could he do so. This is because he does not use the force he understands and would make his life easier.
Even so, even in a fairy tale, no one could be in arrears on loans. Because then not only is the compound interest not helping him, but it is working against him (and raising the bank).

If you really understand how it works, you can see that instant reward as a concept is missing from the basic logic. Either way you look, you won’t see the effect in a very tiny amount of time.

Examining possible financial mistakes so far (either in your environment or in your own life), you can basically divide them into two groups:

• in case of loan repayment (even for loans with very high interest rates) you don’t accidentally pay a penny more to the bank than is obligatory, because you would know where to put the money (for example: on vacation)
• and when investing, you either don’t set aside a single penny or think only in micro distances because you don’t want to commit your money in the long run.

If you could take just one word home from this post, let it be Patience! This is because compound interest can only work for the patient.

The basic logic of compound interest

What would you like to get?
10.000 HUF every day, or 1 HUF today so that you get 2x as much every day? (Beware, the question is tricky!)

If you chose HUF 10.000 per day, you will receive a total of HUF 310.000 by the end of the month. Not bad, but compared to the doubling 1 HUF, it’s pretty skinny. By the end of the month, you would have 2.1 billion HUF 1 (if you can find so much space for that).

Let’s add that in order to be able to double that 1 HUF every day, you have to achieve a 100% return on a daily basis, which can mean quite high annual interest rate. But I think you guessed it was just an example.

Looking at very dry math, a slightly more lifelike example: thinking of 1-year commitments and fixed interest rates:

Current capital: HUF 1.000.000
Interest: 5%
Period: 10 years
Amount available at the end of the period using compound interest: HUF 1.628.894

If you did not do so, you would only return the original amount, HUF 1.500.000 would come together.

By using compound interest, you achieve the same as if

• you would have invested a quarter of a million more (but therefore you would have had to work for a quarter of a million),
• or you would have received 6.2% interest instead of 5%. (if there is anyone who gives you so much more)

Download the Silver Moon compound interest calculator and see how much higher simple interest you should get if you use compound interest.

In real life, in order for your money to grow at a faster rate, you need at least 1 of the following:

• higher interest / yield
• a larger starting amount or additional investments during the period
• more time to grow.

The use of compound interest in everyday life.

On most blogs, you can read the calculation method with or without a formula (any smartphone can do it for you, or you can also access financial calculators on SilverMoon if you prefer), or when using it in everyday life, they usually suggest the following. If you know:

• the principal and the term, you can calculate the required, say, expected interest
• the principal and interest, you can calculate how long it will take to reach your goal
• if the interest and the time period, then you can calculate either the required starting amount or the expected final amount
• you can use it when making a bank deposit to calculate how much it will be in X time, or how long you have to keep the money in for your purposes
• you can take advantage of borrowing to calculate the interest payable.

In other words, a very hyper-super method is compound interest.

What’s the problem with that?

The first three are more indicative. You will find out if you have a chance to accomplish the goal by using compound interest. Elsewhere it is not very good, at most math lesson for example books.

Extreme example: you have calculated that with a 100% expected annual return of 100 million with an initial investment of about 100 years and your dream will come true. Well, maybe plan again.
But in order to use it in real life, you also need a suitable financial product. I mean, one that brings in the same amount for years, moreover, it is guaranteed to know this, and even above inflation. (To do that, however, you would need to know how much the base rate will be in, say, 3 years, but no one would even know next year)

A little interesting:

• Rule 72 allows you to calculate how long it will take to double your investment. This is perhaps simpler than empowering.
• You can compare the return on an investment with the internal rate of return on another investment.

When borrowing, the bank gives you the interest to be paid, the APR, everything you want, so you have nothing to reckon with here. At least not much.

If you are late, the system calculates interest on a daily basis completely automatically for you. So I really hope you don’t math, how long you can go, but repay as soon as possible. (Option “B” is to chat with the recovery department about the rescheduling, but you will not be asked to calculate compound interest there either.)

Although banks accumulate money in savings accounts, because they are charged very low interest rates, the effect of compound interest rates will also be negligible. When I worked at the bank many years ago, the system already had the option to roll back interest at the balance sheet date, but you will not beat inflation with a bank deposit at all.

Compound interest makes investing far more efficient. It’s like you got a much higher simple interest rate. Download the Silver Moon Calculator to see for yourself.

What should you do if you want to use the compound interest for your own benefit?

If you also want to observe actual growth in purchasing power, you need to look a little more outward than your bank account. The logic of compound interest is true for any investment.

If you choose bonds, stocks, mutual funds, it is also true that the larger the starting amount, the greater the end, and the more time available, the greater the expected growth.

Now you can say that it is risky, and that the stock markets have also fallen because of the coronavirus. This may even be true.
Basically, however, the market moves upwards so that the patient can observe the effect of compound interest. Moreover, now that the markets have reorganized, you can buy relatively cheaply. This is when you make the most of the cost average effect.
If you are thinking of investing in this type, either contact us for professional advice, or at least avoid these 7 investor mistakes.

Many of our clients use this to plan a dividend withdrawal: what not them was who was produce can be seen as a quasi-tax cut. So you can say that you can take your money out of the company cheaper than making an ad-hoc decision.

What does compound interest have to do with investments?

I could write that there isn’t much, but then I would be really far from the true. Let’s look at some examples of what you can invest in and how you can take advantage of this principle there.

Although we are talking more about yield here, I could write that compound yield, but it sounds stupid. But the logic behind it is the same: what you produce on the investment, you recycle.

Real estate

You bought and issued it for investment purposes.

Your expected return:

What you should definitely look at is how much money you put in. I emphasize that what you put in, not what the property cost.

I already wrote about this in my article on loans, so just an overview:

CoC: Cash on Cash return: the money that the money invested brings.

CoC = annual pre-tax cash flow / amount invested

If you borrowed to buy the property, the loan repayment is already included in the cash flow and your investment is your own money. And the return you get depends on a lot. (I suggest you read the linked article)

With a completely cash purchase, a high average return of around 2-5% per year is what you can achieve. This is an average for the real estate market, where obviously you can find better, but there are also worse.

Here are the easiest ways to use compound interest here:

• you spin up the repayment of the loan with it, so you achieve numerically the same as if you had an investment that brings in the same amount as the loan.
• you collect (even work in the meantime) and buy another property that you also rent out and so there are already 2 working for you

Individual bond, stock, any commodity product

Whether you bought any bonds or shares, etc., with the help of an expert (eg a private banker) or independently, you did so in the vast majority for the following reasons:

• they pay a dividend on the stock (interest on the bond) and you want to get that
• you expect the exchange rate to rise

If the first is (also) true for you, then it is very easy to use compound interest, maybe you have already figured it out: what you get, under any headline, you recycle.
In the second case, you need at least minimal active management. If you are not a believer in completely passive management, you can do so at any time to realize your profits. You sell at a high enough exchange rate and either buy some cheaper paper or if you expect the exchange rate to fall, you buy the same again only after the fall. Then you can buy more because of your profits, so next time it will work harder.

Investment funds, ETFs

Mutual funds (and other funds that “evolve” from them, such as ETFs) operate in virtually the same way as if you were buying bonds or stocks individually. So here, too, you can follow the logic of compound interest on the one hand for a longer period of time, and on the other hand, by selling one of the funds after an exchange rate rise, you also use the profits to buy something of it.

If you don’t specifically want to deal with this in this way, over time, you’ll typically take advantage of the compound interest raising effect even if you don’t even look after it. There are a lot of companies’ securities in a given investment fund. These, in turn, are not set in stone. They can swap papers according to a pre-fixed logic, so by selling one, they obviously buy another paper at the profit made here. All this is done completely automatically by either a machine or a fund manager.

If you have any questions you can write to us under the contact menu item. I will be happy to read your views in the comments.

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