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Compound interest is the value generated on the amount of variable capital applied to an investment or a credit. We call it compound because we calculate it on the value of capital that constantly increases. After all, the interests are added in each period.

Surely you already knew this part, but how to take advantage of compound interest to live better? Let’s first see how to calculate it and the details of how to take advantage of it.

Today, money is not enough for everything. Finding a good job and saving to live well are seemingly impossible tasks.

Around the world, the millions of people who take their finances seriously understand the importance of investing in creating growth and maintaining value.

What is the compound interest?

The power of compound interest is often underestimated, but it is one of the most potent forces in the world. Compound interest occurs when your investments generate income (it can be dividends in the case of shares). Then those incomes are reinvested so that they generate even more income. 

Therefore, the interests that certain investments give you generate more interest again. That can create a snowball effect where your money can grow exponentially over time.

One way to use compound interest to your advantage is to start investing as soon as possible. That will allow your money to grow over a more extended period of time and give you a higher return on your investment. 

You can also take advantage of compound interest by choosing high-yield savings accounts or investments that offer compound returns.

It is important to note that compound interest doesn’t work miracles. You still need to save regularly and invest wisely to see the most significant benefits. But when used correctly, compound interest can be a powerful tool for building wealth over time.

How does compound interest work?

As we already know, with compound interest, you earn interest on top of the original investment and any previously accrued interest. That causes the total value of the investment to grow at an accelerated rate. To understand how compound interest works, let’s look at a simple example.

Example:

Suppose you have $1,000 in a savings account that earns 5 per cent annual interest. At the end of the first year, you will have earned €50 in interest (€1,000 x 0.05). If you left the money in the account at the end of the second year, you would earn €52.50 in interest (€1,052.50), for a total balance of €1,102.50. The longer you keep your money in the account and continue earning 5 per cent annual interest, the more your balance will grow.

How is compound interest calculated?

When you save money in a bank account, you generally earn interest. The amount of interest your account earns is based on two factors: the size of your deposit and the interest rate. The interest rate is a percentage that tells you how much your bank pays you for lending you money.

This article explains with a formula how compound interest is calculated. 

Compound Interest vs Simple Interest

There are two types of loans in the world of compound interest: simple interest and compound interest. We calculate simple interest using a simple formula that considers the principal amount, the length of the loan in years, and the annual interest rate. This type of calculation results in a fixed monthly payment amount for the life of the loan.

Many large loans use a simple interest formula, such as mortgages and car loans. With this type of calculation, you will always know how much money you have to pay each month to cover the cost of your loan.

By contrast, credit cards and some other loans often use compound interest. Because of this, you should use credit cards wisely and make sure you pay off your statement balance each month.

Companies that pay dividends

There are many different philosophies and strategies when it comes to saving and investing. However, one approach universally accepted as a reliable way to grow your money is to invest in companies that pay dividends.

What are dividends?

In a nutshell, they are the payments companies make to their shareholders out of their profits. They can be paid regularly or as a single payment. In most cases, dividends are paid quarterly if you invest in US companies. Here in Spain, the distribution is usually done once or twice a year.

How do dividends work?

When a company makes a profit, it can reinvest that money back into the business or distribute some of it to shareholders as a dividend. Dividends are payments made to shareholders out of a company’s profits.

The dividend payment amount is generally based on the number of shares an investor owns relative to the total number of shares outstanding. For example, if a company has 100 shares of stock and a person owns 50 of them, that person would receive half of the dividend payment. When you invest in stocks, you are actually buying partial ownership of a company.

The dividends you receive are subject to tax as capital gains in Spain. The dividends will form part of your savings base, and you will pay taxes between 19% and 26%.

Why do dividends work so well?

There are several reasons why dividend-paying stocks tend to outperform the market in the long run. First, companies that pay dividends tend to be more established and profitable than those that don’t. Also, they have a commitment to their shareholders to return a portion of their profits each year. That gives investors a steady income stream, even in tough economic times.

When it comes to dividends, a few different types of companies tend to distribute them. The first type is a company with a lot of excess cash flow. These companies tend to be in stable industries with little or no debt. They also have a history of paying dividends and increasing those payments each year. An example in Spain is Iberdrola.

Another type of company is in the process of liquidating its business. That could be because the company is no longer profitable or because it is being sold piecemeal. In either case, shareholders will generally receive a dividend to give them some return on their investment.

Finally, there are companies that another company buys. In most cases, the acquiring company will pay a special dividend to shareholders from the combined cash flows of both companies.

How to take advantage of compound interest to live better?

Compound interest is a concept that transcends the world of finance. As Naval Ravikant: “All returns in life, whether in wealth, relationships, or knowledge, come from compound interest.”

People typically don’t think about compounding until they are 50 years old and want to retire. However, you can use compound interest to your advantage at any age! Let’s see some examples in Spain…

Urbanitae

“Invest in large real estate projects from just €500. Urbanitae specializes in unique investments with high return potential.” That is the header you will find if you look for them on the Internet. 

It’s that simple: you invest €500 in a real estate project somewhere in Spain. You recover your initial investment plus interest when the project is completed (the time will depend on each project). 

Examples: block of buildings on the Catalan coast, group of chalets in Mijas, Malaga. We leave you the link to the projects already financed to get an idea.

BBVA Invest

«Invest from just 30 euros, with tools to help you choose and the support and experience of BBVA.» And here they give you three options: invest in outstanding funds, look for a specific fund to invest in, or put yourself in the hands of their experts who will study you depending on your profile. Decide in this link how to access your investment funds.

Renta 4 Banco

«Renta 4 Gestora comprises a group of specialists with extensive experience in asset management and capital markets.» You can invest in fixed and variable income funds, mixed funds, or absolute return funds with them. 

And if you get picky, they give you the possibility of contracting fund management tailored to your needs: profiled or thematic funds. You can find all the information on their website and hire the one you like the most.

To live a comfortable life, saving money is vital. You may think you don’t have enough money to save, but even a small amount of money can grow over time with compound interest. 

In short, if you want to get these savings for your financial freedom, start saving now and let the power of compound interest work its magic. If even Winston Churchill said: “Compound interest is the most powerful force in the universe.”

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