Everything You Need to Know About Compound Interest

According to stories, Albert Einstein was once asked what, according to him, was the greatest invention of mankind. Now, if you know of Einstein and his work, you would expect him to give an answer that was rooted in science or physics. Instead, what he had to say was a surprise nobody could have guessed. When posed with the question, Einstein replied, “Compound interest.”

Now, whether or not Einstein actually said those words or whether it is just a story aimed at glorifying this mathematical and economic concept, it remains a fact that compounding interest is a wonder.

What Is Compound Interest?

Compound interest is interest calculated on the initial principal, which also takes into account all the accumulated interest of previous periods of a deposit or loan. At least, that is what it is as far as technical definitions go. But what exactly is it? Instead of depending on technical jargon, let us take a simpler example.

Real-World Analogy

Say you have some Play-Doh. Every time you do something good, you are given half of the Play-Doh you have. If you start with 2 ounces, she gives you half of that (1 ounce). The next day, you start with 3 ounces, so if you do something good, she gives you 1.5 ounces. The third day, you have 4.5 ounces, so if you do something good, you get 2.25 more. Fourth day, with 6.75 ounces to your name, you get 3.375 more ounces. That’s compound interest. Much better than if she just gave you an ounce every day, which is what we call simple interest.

But where is this unlimited supply of Play-Doh coming from? The Play-Doh bank lets other people borrow your Play-Doh so long as they promise to return it with more Play-Doh than they borrowed. The interest you receive is a portion of the Play-Doh that the bank earned.

In essence, that is basically what compound interest is. Knowing that will probably help you understand better what Benjamin Franklin meant when he said, “Money makes money. And the money that money makes, makes money.”

Compounding and the Effect of Leverage

The effects of compounding are different when you apply a good leverage level as part of your investment strategy. Take this example as an illustration.

You want to invest $100 in Fund A, which promises to return 200% of the performance of the asset. Let’s say on the first day, the value is expected to increase by $20 (20% of $100), making your investment $120 in total. If it weren’t for leverage, it would only go up by $10 for the same underlying asset.

Overall, the effect of compounding is usually more noticeable when combined with leverage. Additionally, the performance of a leveraged fund reflects the performance of its underlying index more accurately on a daily basis.

How to Calculate Compounding Interest?

If you had mathematics in school, then you might have encountered a whole chapter dedicated to compounding interest and its many problems. However, this can be very severely complicated. There are a handful of formulas that you would need to keep memorized, and the other mainstream thing to do is calculate it using spreadsheet software like MS Excel.

However, in this article, we will take you through a simple method of calculating compound interest mentally that you can pull out and use for a variety of cases. This is called the Rule of 72. The first thing you can apply this rule to is to figure out how long it will take to get your money doubled.


Let us use an example to illustrate. Say you got the opportunity to invest in something in exchange for a 5% interest on your loan. If you divide 72 by the interest rate, the result will be the amount of time it will likely take to double your money. In this case, if you divide 72 by 5, you will get 14.4 years, which seems like a rather long time to wait.

Another Way to Use the Rule of 72

There is another way to use the Rule of 72, which is the exact opposite application of what we read previously. Say someone claims they will double your money in 4 years. Dividing 72 by that will give you the rate of interest. In this instance, the rate of interest will be 18%, which is quite high. This will also tell you that this operation is quite risky.

Additionally, the Rule of 72 also tells you how many times your money is likely to double over the course of your career. As a final example, suppose you are 30 years old and plan on retiring at 65. At this point, you have 500,000 USD saved up, and the bank gives you a 10% interest. How much can you hope to have when you retire?

Well, using the first application, we can see that the money will double in 7 years (72/10). That means you will have 1 million USD at 37, 2 million USD at 44, 4 million USD at 51, 8 million USD at 58, and 16 million USD at 65. Easy as pie, isn’t it?


Going from the last example, we can see why Einstein and Franklin held compound interest in such high regard. It is a marvel of mathematics and comes in use every day when it comes to finance. So, keep this in mind the next time you are looking to invest in anything!