Compound effect of interest: This is how money becomes a fortune

The compound interest effect

The compound interest effect is very good for private investors to build up their own wealth in the long term. To do this, a saver does not have to do anything except buy a non-distributing ETF or fund. The best way to do this is via a savings plan. This way, no high one-time payments are required and something is simply saved each month. The dividends achieved are not distributed to the shareholder, but are regularly reinvested in the ETF. If we disregard the performance, i.e. price gains, of the ETF, the paid-in capital gradually increases by itself. After an investment period, there is more money in the ETF than was actually paid in. If good price gains are added, a fortune is simply built up over a long investment period.

That is interest

Currently, things don’t really look so good when it comes to interest. For a long time, the bank offered the so-called credit interest rate. This credit interest was the higher, the more long-term the money was invested and the better the so-called market interest rate. Especially if one’s capital was invested for the long term, the interest rate was a kind of “compensation” for the saver. Because with a long-term investment, the money is first “gone” and immediate access to it is usually not possible. However, interest can also be viewed from another angle, namely in the case of loans. In this case, the bank lends money to someone and receives interest in return, in this case the interest rate on the loan.

The interest rate

As everyone should know, the interest rate is always given in percent. This is the fixed interest rate. The interest itself is fixed over a predefined period of time (e.g. for a loan). The interest itself is not always the same and is determined by various factors in the market. For the normal interest rate on credit balances, the Euro key interest rate of the European Central Bank (ECB) is very important. For the credit interest rate, of course, other factors play a role. These include, for example, the amount borrowed, the term of the loan and your own credit rating.

Compound interest

Depending on the investment class (i.e. time deposit, savings account, etc.), interest on credit balances is paid out once a year. Of course, this interest does not have to be spent again immediately. Here it is the better way to invest this interest directly again with. Thus in the next year the capital is increased by the old interest and there is in the next year thereby a higher interest payment. Thus quasi interest for interest is generated. Thus the own capital increases thus nearly by itself and this is called then compound interest effect. The longer the investment period is, the more the compound interest effect can be used. If the interest rate is also quite high, a small fortune can be built up over a long investment period and regular savings plan even for private investors.

​The interest periods

In the case of normal investments such as fixed-term deposits, the interest period is usually one year. Here, the interest on one’s own credit balance is calculated and paid out once a year. The interest periods themselves can of course also vary. So the interest period can be quarterly or even monthly. So when the term “intra-year interest” is used, it means the quarterly or monthly interest period. The calculation and payment of interest is therefore based on the agreed interest period. The following is an example of how the interest period actually affects your capital.

Timeline Interest credited monthly at 3,0% Interest credited quarterly at 3,0% Interest credited annually at 3,0%
01.01.2000 40.000 40.000 40.000
01.01.2001 41.216 41.213 41.200
01.01.2002 42.470 42.464 42.436
01.01.2003 43.762 43.752 43.709

This small example shows very clearly how the individual interest periods actually affect the invested capital. It can be seen that the interest period should be kept as short as possible in order to increase the invested capital as much as possible. Of course, the monthly interest period is best, but this is not offered with many products.

Compound interest and the investment period

As already mentioned, the investment period plays a very important role in compound interest. The following chart shows this very well. In this investment example, the investment period is 50 years with an annual interest rate of 8 percent. Each year, 1,000 euros are invested. The pure investment sum would therefore amount to 50,000 euros. Only through the compound interest effect does the investment sum continue to increase and capital grows over the period into a small fortune. However, this is only an example to better illustrate the effect of compound interest. (Image source: justETF Research)

Compound interest one-time investment and savings plan

For many private investors, the question often arises whether it should be a one-time payment or whether a savings plan is not the better way here. This is also a quite justified question. Who invests his own capital would also like to increase this preferably maximally. With which investment (one-time investment or savings plan) does compound interest have the best effect? In the case of a one-time payment, the initial sum at the start of the investment is naturally already correspondingly high and there is a correspondingly high interest payment in the first interest period. With a pure savings plan, the investment sum is quite small at the beginning and builds up slowly but steadily over the term. Thus, especially at the beginning, the interest payments per interest period are correspondingly lower. It is therefore always advisable in this context to start with a one-time payment and then additionally run a savings plan on it. In this way, the first interest is already correspondingly high and increases over the long term, since the savings plan increases the capital further and further and the compound interest effect is used very well here.

AktienDummy Tipp:

Compound interest is often called one of the most powerful concepts in finance. Find out what it is and how it can work for you.

Compound Interest Calculator

Your savings account balances and investments can grow more quickly over time through the magic of compounding. Use the compound interest calculator to see how big a difference it could make for you.

Compound interest with ETF or fund savings plan

In the case of an ETF or fund savings plan, there is no classical interest. Here, however, there is the dividend, which, so to speak, represents the interest. Here, too, the compound interest effect over the long investment and savings period is very important and should not be underestimated by a private investor. However, it is important to note that the dividends are not distributed directly to the shareholder, but are always reinvested directly. This type of reinvestment is called accumulating. Only by directly reinvesting the “interest” does the compound interest effect become noticeable. For me, this investment model is then the right strategy to provide for old age.

Money investment possibilities

To be able to invest money, there are different investment forms. Each investment form has of course advantages and disadvantages. Also the investment risk is different with each form of investment. Provatanleger should therefore inform themselves in advance exactly which investment form is actually suitable. These forms of investment are available, for example:

Savings account, savings bond, call money, time deposit, bonds, real estate, shares, certificates, investment funds, ETFs, commodities, robo-advisor.

Exploit compound interest effectively

That the compound interest effect is a very good tool for private investors to build up assets, should now have understood everyone. In order to be able to use the compound interest effect correctly, here again briefly summarized, on is to be paid attention. Choose the interest period as short as possible, because here interest or dividends can be reinvested much more often. Do not spend the interest but put it back into the same product. At the beginning it is always best to start with a larger one-time payment, since the interest is higher right at the beginning and can thus accelerate the compound interest effect enormously. The investment period should be as long as possible. Therefore perhaps already with 20 years begin and so 40 or more years over a savings plan its money invest. In addition, keep an eye on the fees. The lower the fees, the better. In the event of a crisis, always stay on the ball and do not suspend savings plans here. This can even be advantageous in the long term, because the average prices are lowered by the savings plan (cost-average effect).