Compound interest does, indeed, affect the future value of any interest-paying investment. The assumption with all compounding interest equations, however, is that you do not spend the interest, but instead promptly reinvest the interest back into the same investment. Not all investments pay interest, however. In this case, you will count on capital growth, rather than interest, for any gains in this investment.
The Time Value of Money
One of the central axioms in financial theory is that a dollar in your hand today is worth more than the promise of a dollar in your hand a year from now. In practical terms, however, the difference between these two values is determined every day by the free market. The difference between a dollar today and a dollar a year from now is equal to the prevailing interest rate. Sometimes investors are willing to pay more for the promise of a dollar in hand a year from now, and sometimes investors are willing to pay less. If borrowers are routinely able to raise 95 cents for the promise to repay a dollar in one year, then the prevailing interest rate is just over 5 percent: 0.05 / 0.95 = 0.0526.
Some investments, such as bonds and rental real estate, generate a regular or semi-regular income. However, income from bonds and real estate is rarely automatically reinvested into the same security if you own these items directly. Instead, you may want to own a mutual fund or CD, and elect to have the fund company automatically reinvest your income back into the fund. This will allow your investment to compound. Otherwise you will be stuck looking for a profitable place to invest very small sums, which is difficult to do on a small scale. Interest only compounds when it is reinvested, not spent. The same is true of capital gains.
Financial calculators, or time-value of money calculators (TVM calculators) make it easy to estimate the future value of an investment given a constant rate of interest. You can find them online or purchase a handheld financial calculator to do this for you. When you use one, bear in mind that FV = future value, or value tomorrow; PV = present value, or value today; I, or INT = the interest rate; and Periods is the number of investment periods or compounding periods the investment is held. Where there is no capital growth, the interest rate is actually determinative of future value, assuming the bond issuer or underlying investment.
Rule of 72s
If you don't have a financial calculator, you can estimate how long it takes an investment to double using the Rule of 72s, provided you know the annual compounding interest rate. The Rule of 72s states that if you divide the number 72 by the interest rate on a compounding investment, the result is the number of years it takes the investment to double in value. An investment returning an interest rate of 10 percent should take approximately 7.2 years to double.
- Chart analysis image by Dmitriy Lesnyak from Fotolia.com