Compound interest describes the effect whereby the
you earn on your invested money creates interest again. If the
interest rate remains the same, you will receive more interest
yearly, which means your savings will steadily grow faster.
To better understand compound interest, it makes sense to explain it with a simple example:
Let’s say you have €1,000 in your savings account. This savings account pays you 5% interest per year. With this interest rate, you will receive 50€ of interest after the first year, which would increase your savings to 1,050€. In the second year, the 1,050€ would earn interest, bringing your interest in the second year to 52.50€. Therefore, you would have 1.102,50€ on your account after the second year.
However, since there is currently hardly any interest on savings accounts, it may make sense to invest part of your money elsewhere to achieve this effect because the capital market has a similar effect in the form of yield on yield.
Do you find the explanation helpful?