Compound interest is often hailed as one of the most powerful forces in finance. In fact, Albert Einstein allegedly called it the eighth wonder of the world, though the exact attribution remains debated. Regardless, the principle is undeniably powerful.
Compound interest is the process where the money you earn (interest) earns interest itself. Unlike simple interest, which is calculated only on the principal amount, compound interest is calculated on the principal plus all previously earned interest.
The basic formula for compound interest is: A = P(1 + r/n)^(nt)
Where: - A = Final amount - P = Principal (initial investment) - r = Annual interest rate (decimal) - n = Number of times interest is compounded per year - t = Time in years
The power of compound interest lies in its exponential nature. Unlike linear growth, compound growth accelerates over time. The longer your money compounds, the more dramatic the effect.
Consider a $10,000 investment at 7% annual return: - After 10 years: ~$19,672 - After 20 years: ~$38,697 - After 30 years: ~$76,123
Notice how the growth accelerates in later years. This is the magic of compounding.
One of the most important lessons from compound interest is the value of starting early. Even small amounts invested young can outgrow larger amounts invested later.
For example, if person A invests $5,000 per year for 10 years starting at age 25 and then stops, versus person B who starts at age 35 and invests until age 65, person A's total contributions are half of person B's. Yet person A often ends up with more money due to the extra 25 years of compounding.
Compound interest rewards patience and consistency. The earlier you start, the smaller your contributions need to be to reach your goals. This is why financial experts emphasise starting retirement savings as early as possible, even if you can only afford small amounts.
Understand the difference between compounding frequencies and why more frequent compounding can lead to better returns.
Understanding historical returns, market cycles, and how to set reasonable expectations for your investments.
Use our interactive calculators to see how compounding works with your own numbers.
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