Compound interest is one of the most powerful and important concepts in personal finance. In fact, it’s the secret to multiplying your money at an accelerated rate — whether you prefer saving, investing or both. But what is compound interest?

Compound interest (or CI) is simply the interest you earn on your interest. In other words, it’s the returns on the original amount you’ve saved or invested (your principal) and any other interest you might have gained earlier. It’s a powerful concept that can help your money grow over time.

In this article, we’ll show you how compound interest works and explore how you can calculate compound interest on your savings or investments. Then, we’ll dive into the Rule of 72 and discuss how you can make the most of compound interest in Nigeria today.

What is compound interest and how does it work?

We’ve always highlighted the importance of saving and investing here on the PiggyVest Blog, but our advice would be incomplete if we didn’t tell you about the wealth-creating powers of compound interest.

So, how does it work?

Well, imagine you have some money and decide to pay yourself first by saving or investing a part of it (as the 50-30-20 budgeting rule suggests). You could put it in a safe and secure platform like PiggyVest to earn some extra money.

This extra money is your interest. If you use PiggyVest, you can earn up to 35% interest yearly — depending on which saving or investing option you choose.

With compound interest, you get a little bonus — not just on the original money (or principal) you put in — but also on the extra cash (interest) you’ve earned. Then, this new bonus gets added to your account — and next time, the bonus is calculated on that bigger amount. Over time, you keep getting bonuses on your bonuses, and your money grows faster than if you only got bonuses on the original amount.

An excellent way to think about it is to imagine your principal as a party. Compound interest is the DJ playing a mashup of Amapiano and Afrobeats. As the party goes on, not only does the DJ spin tracks for your original guests but also for the new friends who join.

So, the longer the party goes on, the more lively and entertaining it becomes!

What is the compound interest formula?

Now that we’ve gotten the explanation and definition out of the way, let’s get a bit technical. As you’d expect, compound interest relies on a formula. You can use this formula to determine how much money you’ll have if you save or invest in an asset offering compound interest returns.

Here’s the compound interest formula:

CI = P ( 1 + I/n )^nt – P

Where:

• CI is the compound interest at the end of the period
• P is your principal
• I is the annual interest rate
• t is the number of years you’re saving or investing
• n is the number of compounding periods per year

To calculate compound interest, you multiply the initial principal amount by one plus the annual interest rate divided by the number of compounding periods per year, raised to the power of the number of compound periods multiplied by the number of compounding periods per year. Then, subtract the total initial principal from the calculated value.

To illustrate, let’s say you decide to save ₦1,000,000 for five years in an opportunity that compounds annually (once a year) with an interest rate of 7%. Your interest at the end of the first year will be ₦70,000. At the end of the second year, it’ll be ₦144,900.

A fundamental assumption with compounding is that you reinvest the interest you earn at the same rate (or a better rate) than the original investment. In this example, the 7% interest is constant year-on-year.

In five years, you’ll get ₦402,551. Therefore, you’ll have a total of ₦1,402,551 at the end of your saving period. Pretty cool!

Compound interest is impressive, but we’ll need some context to understand its power. So, let’s compare it with a concept you’re more familiar with — simple interest.

What is the difference between simple and compound interest?

The main difference between simple and compound interest is in how you calculate the gains. In simple interest, we calculate your bonus linearly on only the original principal using the same interest rate — regardless of the period. However, in compound interest, your returns come from both your principal and your accumulated interest, which leads to exponential growth over time.

The simple interest formula is:

SI = P I t

Where:

• SI is the simple interest
• P is your principal
• I is the annual interest rate
• t is the number of years you’re saving or investing

Let’s illustrate how it works using the same example we mentioned earlier — ₦1,000,000 for five years at 7% annually. Your returns at the end of the first and second years will be ₦70,000 and ₦140,000, respectively.

In five years, you’ll end up with profits of ₦350,000 and a total sum of ₦1,350,000 — that’s ₦52,551 less than you’d have made if you invested in an opportunity that compounds once yearly for the same period.

This number might seem small, but saving and investing are lifelong pursuits. Therefore, five years is pretty short compared to how long you’ll handle your finances. Besides, some opportunities compound multiple times a year — meaning you’d end up with even more money in the same period if you use compound interest instead of simple interest.

What is the Rule of 72?

The Rule of 72 is a quick and easy formula to determine the approximate years an investment will take to double in value — as long as the annual interest rate doesn’t change. It’s an excellent way to calculate compound interest returns and works in most situations.

You can calculate the Rule of 72 using the formula below:

Number of years to double=72Interest rate

For example, for the opportunity that compounds annually with 7% returns, it’ll take about ten years and three months for you to end up with ₦2,000,000. For comparison, it’ll take about 14 years and three months to end up with the same amount if you invest in an opportunity that offers simple interest.

Remember that the Rule of 72 is only a simplification and may not be as accurate for higher rates of return or over more extended periods. We recommend using the compound interest formula for more precise calculations and assets that compound multiple times a year.

Final thoughts

You need to understand several money-related concepts if you’re seeking to build generational wealth, and compound interest is one of the most important. This small but powerful idea can elevate your finances to new heights and help you reach your money goals in record time.

Are you considering saving with PiggyVest and unsure what your returns might look like? Then, try out our free interest calculator! It provides an excellent visual of your total savings over a period and shows the total interest you’ll receive.