🌱 BeginnersWhat is compound interest and how does it work?
Compound interest is the return you earn not only on what you put in at the start, but also on the return that has already been added. Your gain starts generating its own gain. It sounds small, but over many years it creates a snowball effect: your money grows faster and faster. The difference from simple interest, where you earn the same amount each year on the principal only, gets bigger every year. In this article you will see the formula, a worked example in Jamaican dollars, and the rule of 72.
The formula
The basic formula is: final amount = deposit × (1 + rate) to the power of the number of years. The rate is entered as a decimal, so 5% becomes 0.05. The number of years sits in the exponent, and it is the exponent that produces the acceleration.
The more often the return is added to the balance (monthly rather than annually), the stronger the effect, because your return starts compounding sooner. In a unit trust this happens continuously through the unit price and reinvested distributions.
A worked example in Jamaican dollars
Say you put J$1,000,000 into a unit trust that returns 8% a year on average and leave the money for 20 years without adding or withdrawing anything. With simple interest you would get 20 × J$80,000 = J$1,600,000, a total of J$2,600,000. With compound interest it becomes roughly J$1,000,000 × 1.08 to the power of 20, which is about J$4,660,000 — over two million dollars more, purely from return on return.
If you also add a fixed amount every payday, the effect is stronger still, because each new contribution starts compounding from that point. That is why starting early and keeping going usually matters more than the size of your first deposit — and why a monthly pension or unit trust contribution builds up so much over a working life.
Time, the rule of 72 and inflation
The rule of 72 is a quick way to estimate how long it takes for a sum to double: divide 72 by the annual return as a percentage. At 8% a doubling takes about 72 ÷ 8 = 9 years. At 3% it takes 24 years.
In Jamaica you also have to think about inflation, which has often run in the mid-single digits. If an investment returns 8% and inflation is 5%, your real return is only about 3%. The same rule works against you in debt where interest compounds, such as an unpaid credit card balance, where the debt grows faster and faster if you only pay the minimum.
Frequently Asked Questions
- What return should I assume?
- Use a cautious figure after tax and fees, and ideally after inflation. For a broad unit trust or an equity fund, mid-single-digit real returns over the long term are a reasonable planning assumption, but returns are not guaranteed and vary a lot from year to year. A savings account rarely beats inflation.
- How often does compound interest get added?
- On a savings account, usually monthly or quarterly. In unit trusts and pension funds it happens continuously through the unit price and reinvested income. The more often the return compounds, the bigger the effect.
- Does compound interest work with small amounts?
- Yes. The effect depends on the return and the time, not on the size of the amount. A small regular contribution given many years can grow into a significant sum — which is the whole idea behind a monthly pension or unit trust plan.
Informational content, not financial, tax or legal advice. Check amounts, limits and current rules directly with the official sources (the Ministry of Labour and Social Security, the Bank of Jamaica, Tax Administration Jamaica, the Jamaica Deposit Insurance Corporation) before making a decision.
