Compound interest
Find out how interest works over time and is a vital factor to wealth creation.
Simple interest vs compound interest
Interest is the cost of borrowing money or the return on lending money. There are two main types: simple interest and compound interest.
Simple interest
Simple interest is calculated only on the original principal amount that is borrowed or lent. It doesn't grow over time.
Example: If you invest $1,000 at 5% simple interest per year, you'll earn $50 each year. After 10 years, you'll have $1,500 ($1,000 + $500 in interest).
Compound interest
Compound interest is calculated more than once, on an ongoing basis. The interest is calculated on both the original principal amount and any previously earned interest. This means your money grows faster (or a debt grows larger) because there is interest accruing on interest.
Example: If you invest $1,000 at 5% compound interest per year, after 10 years you'll have $1,628.89. The extra $128.89 comes from earning interest on your interest.
How compound interest works
Compound interest is often called the eighth wonder of the world because of its powerful effect on wealth accumulation over time.
The power of compounding
The key to compound interest is time. The longer your money compounds, the more dramatic the growth. This is why starting to invest early, even with small amounts, can lead to significant wealth over decades.
Compound interest formula
The formula for compound interest is:
A = P(1 + r/n)nt
Where:
- A = Final amount
- P = Principal (initial amount)
- r = Annual interest rate (as a decimal)
- n = Number of times interest compounds per year
- t = Time in years
Frequency of compounding
The more frequently the interest compounds, the more you'll earn. Common compounding frequencies include:
- Annually: Interest compounds once per year
- Semi-annually: Interest compounds twice per year
- Quarterly: Interest compounds four times per year
- Monthly: Interest compounds 12 times per year
- Daily: Interest compounds 365 times per year
Note: When comparing investment options, always check the compounding frequency. A higher interest rate with less-frequent compounding may actually earn less than a lower rate with more frequent compounding.
Practical examples
Example 1: Starting early
Sarah invests $5,000 at age 25 at 7% annual return, compounding monthly. She never adds more money.
- At age 65 she'll have $80,000
Tom waits until age 35 to invest the same $5,000 at the same rate.
- At age 65 he'll have $40,000
Starting 10 years earlier doubled Sarah's final amount, even though she invested the same principal.
Example 2: Regular contributions
If you invest $200 per month starting at age 25 at 7% annual return:
- At age 65 you'll have $525,000
- Total invested: $96,000
- Interest earned: $429,000
Regular contributions, combined with compound interest, create significant wealth over time.
Key takeaways
- Compound interest allows your money to grow faster because you earn interest on your interest
- Time is the most important factor – start investing early
- Regular contributions amplify the power of compound interest
- Higher compounding frequency (monthly vs annually) increases returns
- Compound interest works for you when investing, but against you when borrowing