What is compound interest?

Have you ever watched a snowball rolling down a hill? At first, it’s still small and grows only slowly. But the farther it rolls, the more snow sticks to it. As a result, it grows faster and faster and eventually becomes very large. This is exactly how compound interest works.

But let’s start from the beginning: What exactly is interest?
Interest is the compensation you receive for temporarily giving your money to someone else, for example a bank. The bank can lend or invest this money in the meantime and pays you a certain amount in return: the interest. With other forms of investment like stocks or real estate, you also receive regular returns, but they are not referred to as "interest" although they serve a similar function: they’re a kind of reward for investing your capital.

Compound interest is easy to understand: When you earn interest on your investment and don’t spend that interest but leave it in your account, you receive interest the next year not just on your initial investment but also on the interest you’ve already earned. In other words, you earn interest on interest.

Here’s an example: Let’s say you deposit €100 into a savings account today, and it earns 5% interest per year. In the first year, you’ll receive €5 in interest, bringing your balance to €105. In the second year, you earn 5% again, but now on €105 instead of €100. This gives you €5.25 in interest, and your balance increases to €110.25.

From Compound Interest to the Compound Interest Effect

The compound interest effect kicks in when you invest money over a longer period of time. Initially, your wealth grows slowly, and the annual interest increase is hardly noticeable. But over time, the growth accelerates: the more interest is added to your original capital, the higher the following interest payments become. This is well illustrated by a snowball rolling down a hill. The bigger it gets, the more snow sticks to it, and the faster it grows. This accelerating growth is called exponential growth.

Here’s how powerful this effect is:
After about 15 years, your initial €100 investment will have grown to more than €200. More than half of that amount — over €100 — consists of interest alone. For the first time, you’ve earned more from interest than you originally invested.

Each year, your balance grows faster:

• Year 15: The first blue flag marks the point where the earned interest surpasses your original investment.
• Year 48: Your balance has grown tenfold.
• Year 95: Your initial capital has increased a hundredfold.

Why Financial Experts Recommend Long-Term Investing

The compound interest effect is one of the main reasons financial experts recommend staying invested long-term in assets that may fluctuate greatly in the short term but deliver solid returns over time.

A vivid example is the global stock market: historically, its average inflation-adjusted return is about 7% per year. In the short term, however, it fluctuates much more. Those who invest only for a short time face a high risk of loss and miss out on the potential of compound interest. But if your money remains invested long-term, those fluctuations even out over time, returns approach the average 7%, and your investment grows faster and faster thanks to compound interest.