What is Compound Interest? What Does Compound Return Mean?

If you have ever invested money or borrowed money, you may have heard of the terms compound interest and compound return. But what do they mean and how do they affect your money? In this blog post, we will explain the concepts of compound interest and compound return, and show you some examples of how they work.

Compound interest is the interest that is calculated not only on the initial amount of money, but also on the accumulated interest of previous periods. In other words, compound interest is interest on interest. This means that your money grows faster over time, as you earn interest on both the principal and the interest.

Compound return is the rate of return that reflects the effect of compounding over a period of time. It is also known as the annualized return or the geometric mean return. Compound return measures how much your investment has grown or shrunk over a certain period, taking into account the reinvestment of dividends, interest, or capital gains.

To illustrate the difference between compound interest and compound return, let us look at an example. Suppose you invest $10,000 in a savings account that pays 5% interest per year, compounded annually. After one year, you will have $10,500 in your account. The interest you earned is $500, which is 5% of $10,000. This is also your simple interest rate, which is the interest rate that does not take into account compounding.

However, after two years, you will have $11,025 in your account. The interest you earned in the second year is $525, which is 5% of $10,500. Notice that you earned more interest in the second year than in the first year, because you earned interest on both the principal and the previous interest. This is compound interest.

The compound return for the two-year period is not simply 5% + 5% = 10%. Rather, it is calculated as follows:

Compound return = (Final value / Initial value)^(1 / Number of years) - 1

In this case,

Compound return = ($11,025 / $10,000)^(1 / 2) - 1

Compound return = 1.1025^(0.5) - 1

Compound return = 0.0494 - 1

Compound return = 0.0494 or 4.94%

The compound return is lower than the simple interest rate because it takes into account the effect of compounding over time.

As you can see, compound interest and compound return are important concepts to understand when it comes to investing or borrowing money. They can make a big difference in how much money you end up with or owe over time. The more frequently compounding occurs, the faster your money grows or shrinks. Therefore, it is wise to look for investments that offer high compound returns and avoid loans that charge high compound interest.