Understanding the interest on interest effect can be one of the most rewarding pieces of knowledge when it comes to personal finance. This effect isn't just a mathematical curiosity — it's the foundation of how you can build a fortune over time. In this blog post we will explore what interest on interest means, how it works and we will also give a calculation example with an interest rate of 4% to make it as clear and simple as possible.
In this post that takes you 5 minutes reading you will learn more about interest on the interest rate effect and the snowball effect.
What is interest on interest?
Interest on interest, or compound interest, occurs when you earn interest not only on your original deposits, but also on the interest that those deposits have already generated. Think of it as a snowball rolling down a snow-clad hill; the further it rolls, the bigger it gets.
How does interest on interest work?
To illustrate this, let's use an example:
Suppose you save $10 000 in one savings account with a fixed interest rate of 4% per annum. We also assume that you do not withdraw any money and that the interest is capitalized annually, which is common in many savings accounts.
Year 1:
- Your deposit: 10 000 kr
- Interest (4%): 400 SEK
- Total balance after year 1:10 400 kr
Year 2:
- Interest (4% of SEK 10,400): 416 SEK
- Total balance after year 2:10 816 kr
Year 3:
- Interest (4% of SEK 10,816): SEK 432.64
- Total balance after year 3:11,248.64 kr
And so on. After 10 years, without additional deposits, your balance would be $14,802.56. This shows the power of interest on interest — your balance grows faster and faster with each passing year, even if the interest rate and initial deposit amount remain the same.
Factors affecting interest on interest
- Interest rate
The higher the interest rate, the faster your savings will grow. A difference of just a few percentage points can mean thousands of dollars extra in future earnings. - Frequency of capitalization
If interest is added to your balance more often than annually, say monthly or quarterly, this increases the effect of interest on interest. That's because each interest surcharge itself begins to generate additional interest. - Length of time
The effect of interest on interest becomes more noticeable over longer periods of time. The sooner you start saving, the greater the potential return.
When to use interest on interest
Interest on interest can benefit you in many different financial situations, from saving for a pension to building up an emergency buffer. It is a powerful mechanism that anyone who saves or invests should know and take advantage of.
Conclusion
Interest on interest is not just a mathematical principle, it is one of the most powerful tools for building wealth. By starting early, choosing the right form of savings and being patient, your money can grow exponentially over time. The important thing is to remember to start saving -- even small amounts can grow into significant sums with the help of interest on interest.
So take a step today to secure your financial future. Open a savings account that provides interest on interest, and watch your money grow over the years. Every dime you save is one step closer to your financial freedom.
We hope this guide has given you a better understanding of just how powerful interest on interest can really be. Start your savings today and let the math do the heavy lifting for you!
Questions and answers about interest on interest
What is meant by interest on interest and the snowball effect?
Interest on interest, or compound interest, means you earn interest not only on your initial deposit but also on the interest accumulated over time. This can be likened to a snowball effect, where your savings grow faster the longer it rolls forward, because interest is calculated on an ever-increasing amount.
How does interest affect the interest rate effect if the interest rate changes during the investment period?
If the interest rate increases during the investment period, the interest rate effect will accelerate and your capital will grow faster. Each interest period then calculates a greater return on the accumulated capital, resulting in a higher end value of your investment. To adjust calculations for different interest rates over time, the interest rate\ (r\) in the calculation formula is updated for each period in which a change occurs.
How much will my money be worth in 20 years?
To calculate the value of an investment after a certain time with a fixed interest rate at which the interest is capitalized annually, one uses the following formula:
AND=P× (1+r)n
where:
- AND is the future value of the investment.
- P is the original amount (principal).
- r is the annual interest rate (expressed as a decimal point, so 4% is 0.04).
- n is the number of years the money is invested.
To figure out what a $10,000 investment is worth after 20 years with an interest rate of 4% per annum, we put these values into the formula:
AND = 10,000 × (1+0.04) 20 (years)
After 20 years, an initial investment of SEK 10,000, with an annual interest rate of 4% and without additional deposits, would be worth approximately SEK 21,911. It clearly shows how powerful the effect of interest on interest can be over longer periods of time. With reservation for exchange rates, etc.
