Compound interest is often called the "eighth wonder of the world" because of its power to grow wealth over time. Unlike simple interest, which is calculated only on the initial principal amount, compound interest is calculated on the principal amount plus any interest that has already accumulated. This means your money grows at an accelerating rate, with your earnings also starting to earn interest.
How Compound Interest Works
The formula for compound interest is:
A = P (1 + r/n)^(nt)
Where:
A = the future value of the investment/loan, including interest
P = the principal investment amount (the initial deposit or loan amount)
r = the annual interest rate (as a decimal)
n = the number of times that interest is compounded per year
t = the number of years the money is invested or borrowed for
The key differentiator is the compounding frequency (n). The more frequently interest is compounded, the faster your investment will grow, assuming all other factors remain constant. For example, daily compounding will yield slightly higher returns than monthly compounding over the same period.
Why is Compound Interest Important?
For investors, compound interest is a cornerstone of long-term wealth creation. By reinvesting earnings, individuals can significantly increase their portfolio's value over decades. It's crucial for retirement planning, savings goals, and understanding the true cost of loans.
Example Calculation
Let's say you invest $1,000 (Principal) with an annual interest rate of 5% (0.05 as a decimal) for 10 years. If the interest is compounded annually (n=1):