There is a way to increase the profitability of your investment significantly – this is called compound interest. Despite the name, there is nothing difficult to understand about it.

**Compound interest** is an easy way to increase your return on investment. To apply it, you need not spend but re-invest the income from securities – for example, dividends on stocks or interest on bonds. Compound interest can also be applied when you deposit money with a bank. If the deposit has expired, you withdraw money along with the accrued interest and open a new deposit. But already for a considerable amount. Then interest on the new deposit will be charged not only on the original amount but also on the interest you received from the first one. That is interest on interest. It is from this overlap that the name “compound interest” appeared.

**How effective is it?**

Imagine a magic chessboard, each cell of which doubles everything that you put on it. If you fill each cell with a monetary coin (¢=cent), then putting ¢64 on 64 cells of the board, you will extract 128 coins. In this example, you have used simple common interest with a 100% yield.

Compound interest will work if you put ¢1 in the first cell and then put the received ¢ two into the second cell. Then the second square of the board will turn them into ¢4. Putting this ¢4 in the third box, you extract ¢8 from the fourth. If you walked through all the cells of this magic board, then your wealth would increase to 16 quintillions (a number with 18 zeros). Unfortunately, there is no such board, and actual returns, on average, are far from doubling. But the principle works effectively.

Let’s look at a more real-life example – you invested $ 100 in a share with a stable semi-annual dividend yield of 10%. If you apply a simple percentage, then your yield will always be 10%. In ten years, you will triple your capital. But imagine if, having received the first dividends, you buy the same shares on them. Now you will receive the next 10%, not from ¢100, but ¢110. What will it give? You can find that you will triple your capital through simple calculations, not in ten but six years. And in ten years, your money will grow almost sevenfold.

Compound interest can be used not only when receiving interest and dividends. Make a profit on the growth of stock quotes, then invest this profit in whole or in part again in securities. You will be able to increase the profitability of your investments more efficiently and faster.

**Derivation of the formula for calculating compound interest**

The formula for compound interest, including principal sum, is

A = P (1 + r/n)^{(n.t)}

A = the future value of the investment/loan,

P = the principal investment amount,

r = the annual interest rate (decimal)

n = the number of times

t = the time the money is invested/ borrowed.

If you want to calculate the compound interest only, you need to subtract the principal from the result. The formula would be

Compounded interest only (without principal):

P (1 + r/n)^{(n.t)}– P

Sample:

If an amount of $2,000 is deposited into a savings account at an annual interest rate of 5%, compounded semi-annually, the value of the investment after 15 years can be calculated as follows

P = 2000

r = 5/100 = 0.05 (decimal).

n = 2

t = 15

If we plug those figures into the formula, we get the following:

A = 2000 (1 + 0.05 / 2) ^{(2 * 15)} = 4195.14

So, the investment balance after 15 years is $4195.14

The compound interest only is $4195.14 – $2000= $2195.14

Any amount above the principle is haram in Islam and considered as riba or usury. Therefore, a compound interest that is made on top of interest (i.e., conventional savings accounts or loans) is prohibited. However, there is nothing wrong with understanding the calculation of compound interest. Knowing this formula will help investors understand the present and future value of their investment. If you want to invest in a halal way, you can check out the shariah-compliant stock at Musaffa.

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