Compound Interest
Compound interest occurs when you earn interest on both your original deposit and on the interest that has already accumulated over time.
Definition
Compound Interest is interest calculated on the initial principal of an account, plus all of the accumulated interest from previous periods. In simple terms, it is "interest on interest."
Albert Einstein famously called compound interest the eighth wonder of the world. "He who understands it, earns it; he who doesn't, pays it."
Why It Matters
Compound interest is the fundamental mathematical mechanism behind long-term wealth building. It causes your savings to grow exponentially rather than linearly.
Because your earned interest generates its own interest, the earlier you start investing, the more time the math has to work its magic. Time is the most important variable in the compound interest formula—far more important than your principal or your monthly contribution.
Practical Example
Imagine you invest $10,000 at a 7% annual return, compounding yearly:
- Year 1: You earn $700 in interest. Balance = $10,700.
- Year 2: You earn 7% on $10,700, which is $749. Balance = $11,449.
- Year 10: Your balance is $19,671. You earned $1,287 in interest this year alone.
- Year 30: Your balance is $76,122. You haven't added a single penny since your initial $10,000, but your money has multiplied by 7.
You can simulate your own wealth-building timeline using our Compound Interest Calculator.
Frequently Asked Questions
How is compound interest different from simple interest?
Simple interest is only calculated on the principal amount. Compound interest is calculated on the principal AND the accumulated interest.
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