TL;DR: jump to compounding crypto programs here.
Compounding or compound interest was called the ‘eight world wonder’ by no one less than Albert Einstein. Another important statement from him was: “He who understands it, earns it; he who doesn’t, pays it”. With this simple article, we’ll help you become the one that understands it. The most simple explanation is that with compound interest, money makes money. Your initial investment grows by receiving a return (the interest). If this amount is added to the initial investment, the new interest ground is also bigger. Resulting in a cumulative and exponential growth rate.
With simple interest, the interest is only calculated over the original principal, while with compound interest, the interest earned is added to the principal, resulting in a bigger interest ground. The effect is clear with the graph below:
The formula is as follows:
A = P (1 + r/n)^(nt)
A: Future value (Amount)
P: Initial investment (Principal)
r: Annual interest rate
n: Number of times the interest compounds
t: Number of years
One important factor is that the more frequently the interest compounds, the more you will earn. Put simple: you will make more money from an investment that pays the interest every month compared to one that pays every year.
Compounding crypto is exactly the same as normal compound interest, only the underlying crypto holdings are the ‘savings’.
Please note that there are many terms that mean the same thing like: Annual Percentage Rate (APR), Yearly Percentage Rate (YPR), Internal Rate of Return (IRR), Yield-to-Maturity (YTM) and Compound Annual Growth Rate (CAGR).
Compounding Crypto: The Rule of 72
The Rule of 72 is a way to measure how long it will take for your initial investment to double, according to the compound return. Simply divide 72 with the compound return percentage (without the %). Take a look at some examples below to get some more feeling with this concept:
- Investment yielding a 5% compound return = 14.4 years to double
- Investment yielding a 10% compound return = 7.2 years to double
- Investment yielding a 50% compound return = 1.44 years to double
Please not that the rule of 72 gives you and estimate, the actual calculation is more complex. The calculation is most exact at a compound rate of 10%, the further away your rate is, the less exact the rule becomes.
But what makes compounding so important? Well this is because we all pay an invisible tax called ‘inflation’. Let alone the fact that there is zero interest on your bank accounts (some banks even charge negative interest!), the general price level increases with 2% every year. So lets say that your bank charges 1% negative interest and the price level increases with 2%. This means that you have a negative interest of 3% total. According to the rule of 72, your purchasing power halves every 24 year! Simply meaning that your dollar today is only worth half a dollar in 24 years.
But today we’re not talking dollars, but crypto compounding. But this concept is very, very important to understand and see that crypto works different and is not tied to a central banking system.
How Can You Earn Compound Interest on Crypto?
Now the concept is clear, the big question is: how can you earn compound interest on crypto?