Compound interest
When your returns start earning returns of their own, your money grows like a snowball. Slowly at first, then faster and faster.
Returns on returns
Say you invest 1,000 euros and it grows by 7 percent a year. After one year you have 1,070 euros. In year two, it is no longer just your 1,000 euros that grow, but the full 1,070. You also earn on the 70 euros you gained in the first year. That is compound interest. With stocks, it happens when gains stay invested and dividends are reinvested. In the first year, the difference is tiny. After decades, it is huge.
The maths of 100 euros a month
Take a simple savings plan: 100 euros a month for 30 years, at an assumed 7 percent a year. In total you pay in 36,000 euros. Your account would show around 117,000 euros. More than two thirds of that you never paid in yourself. It came from returns on returns. The shape is what matters: after 10 years you have about 17,200 euros, after 20 years around 51,000. Most of the growth happens at the end.
Approximate result after 30 years of 100 euros a month at 7 percent a year, before tax and fees. Paid in: 36,000 euros.
Time is what matters most
With compounding, what counts most is how long your money gets to work. A rule of thumb helps: divide 72 by the yearly return in percent. The result is roughly how many years it takes your money to double. At 7 percent, that is just over 10 years. Start at 25 and you have several doublings ahead of you before retirement. Start at 45 and you need to put in far more to reach the same result. That is why starting early matters more than starting big.
The 7 percent is an example, not a promise. According to the German Stock Institute's return triangle, a DAX savings plan has in the past mostly returned 6 to 9 percent a year over long periods. In between came years of heavy losses. From March 2000 to March 2003, it fell by more than 70 percent.
What about a savings account?
Compounding works in a savings or instant-access account too. The snowball is just much smaller there. For many years, classic savings books paid almost no interest, and instant-access rates have mostly sat well below historical stock returns. Meanwhile, inflation eats away at your money. If the interest rate is below inflation, you lose purchasing power even though the number in your account goes up. On the plus side, that money is safe and always available, which makes it the right place for an emergency fund.
How long it takes money to double at 7 percent a year. Rule of thumb: 72 divided by the interest rate.
What is the snowball rolling on?
In Germany, a monthly savings plan, the Sparplan, is a popular way to put compounding to work. A fixed amount goes into your investment automatically every month, so you never have to time the market. Which leaves the question of what to invest in. Putting everything on a single stock is risky. If that one company stumbles, your snowball melts. How to spread the risk across many shoulders is the next chapter.
In short
- With compound interest, your returns earn returns of their own, and growth speeds up over time.
- 100 euros a month at 7 percent a year grows to about 117,000 euros in 30 years from just 36,000 paid in. This is not guaranteed.
- Time is the strongest lever. Starting early and investing regularly often does more than large one-off sums.