Compound interest is one of the most powerful concepts in finance. Unlike simple interest, which is calculated only on the principal amount, compound interest allows your money to grow at an accelerated rate because you earn interest on your interest. This powerful concept is often referred to as "interest on interest" and is a fundamental component of wealth creation in investing.
The magic of compounding happens over time. The frequency of compounding—whether it's daily, monthly, quarterly, or annually—can significantly affect the total amount of interest earned. The more frequently interest is compounded, the higher the final return will be.
For example, a savings account with a 5% annual interest rate that compounds monthly will yield more than an account with the same rate that compounds annually. This is why understanding compound interest is essential for making informed decisions about savings accounts, investments, and loans.
Albert Einstein reportedly called compound interest "the eighth wonder of the world," saying "He who understands it, earns it; he who doesn't, pays it." Whether or not he actually said this, the sentiment captures the importance of understanding this concept for building long-term wealth.
Key Variables
- A: Final amount
- P: Principal (initial investment)
- r: Annual interest rate (decimal)
- n: Number of times interest compounds per year
- t: Time in years
Real-World Example
Imagine you invest $10,000 at an annual interest rate of 5%.
- Year 1: You earn $500. Total: $10,500.
- Year 2: You earn 5% on $10,500 ($525). Total: $11,025.
- Year 10: Your investment grows to roughly $16,288, without adding another penny.
Key Takeaways
- Start early: The longer your money compounds, the more dramatic the growth
- Compounding frequency matters: Daily compounding beats annual
- Rule of 72: Divide 72 by your interest rate to estimate doubling time
- Compound interest works against you with debt (credit cards, loans)