2024-08-14
What is compound interest? How does it work? Let's break it down.
Compound interest is one of the most powerful financial concepts, often described as the "eighth wonder of the world." 1 This principle is simple: you earn interest not only on your initial investment but also on the interest that accumulates over time. The longer you let your money grow, the more exponential the growth becomes.
At its core, compound interest is the process where the interest earned on an investment is reinvested, generating more interest. This cycle repeats, causing your wealth to grow at an increasing rate. Unlike simple interest, where you earn interest only on the principal amount, compound interest works by growing your balance by the interest accrued during each period, effectively allowing your money to "work for you." 2
For example, if you invest 1,000 dollars at a 5% annual interest rate compounded yearly, after one year, you’ll have $1,050. The following year, you’ll earn 5% on 1,050 dollars, not just the original 1,000 dollars, resulting in 1,102.50 dollars. Over time, this compounding effect can lead to substantial growth. The more frequently interest is compounded, the faster your money grows.3
The formula for calculating compound interest is:
Where:
To calculate the compound interest with a recuring investment, you can use the following formula:
Where:
Use the calculator below to visualize how compound interest, with or without a recurring investment, can impact your savings over time.
In his book The Price of Time: The Real Story of Interest, author Edward Chancellor delves into the history and significance of interest rates. Chancellor explains how compound interest has played a crucial role in economic development and wealth accumulation throughout history. He argues that understanding the value of time is essential when considering investments and that compound interest is a natural extension of this principle.
Chancellor traces the origins of interest back to ancient civilizations, where it was seen as a way to compensate for the time value of money. He highlights how the concept of compound interest emerged as societies began to recognize the exponential potential of reinvested earnings. The book underscores the importance of time in the growth of wealth, showing that those who understand and utilize compound interest effectively are often those who accumulate the most wealth over time.1
One of the most important aspects of compound interest is time. The earlier you start investing, the more time your money has to grow. Even small amounts invested regularly can grow into significant sums due to the compounding effect. For example, an investment of 100 dollars per month at a 7% annual interest rate could grow to over 120,000 dollars in 30 years.
This is why financial advisors often stress the importance of starting early. As Chancellor notes in The Price of Time,
Time is the most valuable asset one can have when it comes to investing. The longer you let your investments compound, the greater the returns. 1
Compound interest is a powerful tool for building wealth, especially when combined with the understanding of time's value, as highlighted in The Price of Time. Whether you are saving for retirement, building a college fund, or just looking to grow your savings, taking advantage of compound interest can significantly impact your financial future. The key is to start early, remain patient, and let time do the work for you.
Sources:
Chancellor, Edward. The Price of Time: The Real Story of Interest. Atlantic Monthly Press, 2022. ↩ ↩2 ↩3
"Compound Interest - Overview, Components, Practical Examples." Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/knowledge/finance/compound-interest/ ↩
"Understanding the Power of Compound Interest." Investopedia. https://www.investopedia.com/terms/c/compoundinterest.asp ↩