What Is Compound Interest and How It Works
Introduction
Compound interest is often called the “eighth wonder of the world.” It’s a simple concept, but one that has a massive effect on savings, investments, and even debts. Understanding how compound interest works can help you grow your wealth over time—or, if ignored, cost you thousands of dollars.
What Is Compound Interest?
Compound interest is the process where interest is added to your initial money (called the principal), and then future interest is calculated on both the principal and the previously earned interest. This is different from simple interest, which only calculates interest on the principal.
Example of Compound Interest
Let’s say you put $1,000 into a savings account with a 5% annual interest rate:
- After 1 year: $1,050
- After 2 years: $1,102.50
- After 10 years: $1,628.89
The extra growth comes from interest earning interest.
Why Compound Interest Matters
- For savers: Money grows faster.
- For borrowers: Debt grows faster (like credit card debt).
- For investors: Long-term gains can be huge if you start early.
The Power of Time
The earlier you start, the more powerful compounding becomes. A 25-year-old who invests $200 a month could end up with more than double the retirement savings of a 35-year-old who invests the same amount.
How to Use Compound Interest to Your Advantage
- Start saving as early as possible.
- Reinvest dividends and interest.
- Avoid debt that compounds daily.
Conclusion
Compound interest can either be your best friend or your worst enemy. Used wisely, it helps you grow wealth. Ignored, it can make debt overwhelming.
Sources
Disclaimer: This article is for educational purposes only and does not constitute financial advice.