Albert Einstein (14 March 1879 – 18 April 1955), German-born physicist
It is not proven that the famous physicist said this exactly. According to other sources, he said that compound interest is the greatest invention of mankind, or that it is the eighth wonder of the world.
Anyway, there is no doubt that compound interest – or in simpler terms: the interest – plays an important role in our lives. It determines to a large extent what we can afford, and hence our standard of living and quality of life, both today and for the rest of our lives.
But what is it exactly?
In a first stage, don’t worry about the term “compound interest” and let’s look at what we generally mean by interest.
If we deposit our money in a savings or a bank account, i.e. if we put our money at the disposal of a bank, this bank will pay us interest. From our perspective, this is credit interest.
However, if we borrow money from a bank, we are the ones who will have to pay interest to the bank. This is called debit interest.
To understand why interest rates are justified – and why they can rise or fall over time – we have to keep in mind that money is a commodity like any other, and that it is therefore also subject to the law of supply and demand.
Suppose a company wants to build a new factory. To pay for this construction, it needs more money than it has currently available. The company thus creates a demand for money.
Where can it get the money it needs? Well, from those savers who have put some money aside that they don’t need immediately and who are therefore willing to make it available, for a certain period of time, to those who need money immediately. Savers thus create as a supply of money.
But they only do so under certain conditions. Before putting their money on a bank account or, in other words, lending their money to a bank (which in turn will then lend money to the company that needs it)
The bank is the intermediary between the various parties – those who want to borrow and those who can provide money.
The Bank defines the level of credit interest it pays to the savers as well as the level of debit interest to be paid by borrowers.
Interest is expressed as a percentage (%) – this is called the interest rate. It specifies what savers receive on their savings / what borrowers have to pay for a loan for a given period (usually one year).
The interest rate may be either a fixed rate, which does not change during the entire term of the investment or loan, or a variable rate. In this case, it is adjusted periodically.
In simple terms, one can say that the credit interest is the price that savers demand to “offer” their money, and that debit interest is the price that borrowers pay to borrow money.
As we have seen above, money is a commodity like any other. Its price – the interest rate – thus fluctuates according to supply and demand of money. A high supply and a low demand for money depress its price; a low supply and a high demand pushes the price up.
Now we need to distinguish between the “nominal interest rate” and the “real interest rate”.
The nominal interest rate is the one that is fixed when money is deposited in a bank or when a loan is credit is granted.
If you deposit 100 euros on a bank savings account and if the annual credit interest rate is 5%, your deposit will increase to 105 euros in one year. But that does not necessarily mean that the value of your deposit will be 105 euros as well. If prices have also increased by 5% over the same period, the value of your deposit does not change, you will be able to buy exactly the same amount of goods and services in a year as today. So you have gained nothing, the real interest rate amounts to 0%. However, if prices only increased by 3%, the value of the deposit increases by 2%, the real interest rate thus amounts to 2%. And when prices rise by 7%, you will get less for your saved money in a year than you get today, the value of the deposited money decreases by 2% which means that the real interest rate is negative: -2%.
Now let’s come back to the term “compound interest” mentioned above.
In general, the credit interest paid, for example, on a bank balance will be added to the amount invested (capital) and paid into the same account. The interest acquired will then generate credit interest of its own – called compound interest – , that will be added to the account, so that the deposit grows faster and faster over time.
In the same manner, compound interest makes a debt grow faster and faster, if the debtor does not repay it gradually. In practice however, a borrower repays his debt in (usually monthly) installments, so that his debt decreases over the years.