How compound interest works

The basic idea

Compound interest means that your gains earn gains too. If you invest 1,000 lei at 7% a year, after one year you have 1,070 lei. In the second year the 7% applies to 1,070, not to 1,000. The difference looks trivial at first and becomes enormous with time.

Time matters more than the amount

Suppose you set aside 500 lei a month at a 7% annual return.

• After 10 years you have deposited 60,000 lei and have about 85,500 lei.
• After 20 years you have deposited 120,000 lei and have about 253,800 lei.
• After 30 years you have deposited 180,000 lei and have about 584,700 lei.

In the first decade the gain is around 25,000 lei. In the third it is more than 270,000. You deposited the same amount every month. What changed is the size of the sum the return applies to.

Saving for 30 years instead of 20 means depositing half as much again, but ending with more than twice the sum.

Don't forget inflation

Those 584,700 lei in 30 years won't buy what they buy today. At 3% inflation a year, their purchasing power is about 240,900 of today's lei. That is still more than the 180,000 deposited, but the picture is different.

So when you plan for the long term, look at the sum expressed in today's money.

Compounding also works against you

The same mechanism applies to debts and fees. Unpaid credit card interest is added to the balance and earns interest in turn. A yearly management fee shrinks the sum that compounds, year after year.

What a calculation doesn't tell you

A constant 7% return is a simplification. Real investments have good years and bad years, sometimes in a row. The calculation shows the order of magnitude, not a guaranteed result.

Try your own figures in the compound interest calculator.