Compound interest, or the snowball effect

Albert Einstein, the great physicist of the 20th century, called compound interest “the eighth wonder of the world” for a reason. Today, we’re going to take a closer look at this magical concept, which has the power to turn your initial capital into a much larger sum of money over time. If you’re interested in investing, annual returns, or even investments such as life insurance and PEA (Plan d’Epargne en Actions), this notion is crucial.

Definition of compound interest

Compound interest is the interest you earn not only on the initial capital but also on previously accumulated interest. In simple terms, this is the “snowball effect” applied to your initial investment.

The compound interest formula

The compound interest formula is :

\(A = P \left(1 + \frac{r}{n}\right)^{nt}\)

where :

• \(A\) is the final amount, including initial capital and compound interest
• \(P\) is the initial capital or initial investment
• \(r\) is the annual interest rate (in decimal)
• \(n\) is the number of times interest is compounded per year
• \(t\) is the time in years

This formula allows you to calculate the amount of compound interest on your invested capital.

Example in figures

Let’s take an example to illustrate the power of compound interest. Suppose you have invested 10,000 euros in a financial investment in Canada or Luxembourg, with an annual interest rate of 5%. At the end of one year, your capital would amount to :

\(10,000 \times \left(1 + \frac{0.05}{1}\right)^{1 \times 1} = 10,500 \text{ euros}\)

These are simple interests. However, with compound interest, the interest for the second year would be calculated on the new amount of 10,500 euros, and not on the initial capital of 10,000 euros.

The role of time and interest rates

Time and interest rate are two key factors in the calculation of compound interest. A higher interest rate or longer term can have an exponential effect on your final capital. The effects of compound interest are particularly visible over the long term.

Investments and compound interest

Many types of investments benefit from compound interest. Life insurance, for example, is a virtuous investment when combined with this effect. The life insurance PEA is another option that combines the tax advantages of a PEA with the compound interest benefits of life insurance.

Fintech and compound interest

With the advent of financial technology or “fintech,” it has become easier than ever to calculate compound interest. Many online tools allow you to enter your initial capital, interest rate and term to obtain the final amount.

Einstein and Warren Buffett on compound interest

Albert Einstein wasn’t the only one to sing the praises of compound interest. Warren Buffett, one of the most successful investors of all time, attributes much of his success to this “eighth wonder of the world.”

Pitfalls to avoid

It’s important to note that compound interest can also work against you, especially in the case of debt. If you have a high compound interest rate on a debt, the amount can quickly become insurmountable.

In conclusion

Compound interest is a powerful tool that can work in your favor or against you, depending on how you use it. If you invest wisely, it can turn your initial capital into an impressive sum. However, it is essential to understand the different variables, such as annual interest rate and time, that come into play when calculating compound interest.

The impact of compound interest cannot be ignored in any long-term financial plan. Whether you invest in Canada, Luxembourg or any other country, understand the formula and use it to your advantage. Compound interest is, in fact, the eighth wonder of the world from an investment point of view. Understanding them and using them wisely can make all the difference in your financial life.

Remember this famous quote from Albert Einstein: “He who understands compound interest wins, and he who doesn’t, pays it.” So be one of the winners and harness the virtuous power of compound interest.

To find out more, read the article These new ways to invest your money