What Is Compound Interest?
Compound interest, also known as compounding interest, is the interest on a loan or deposits calculated based on the initial principal and the accumulated interest from prior periods. Compound interest can be thought of as “interest on interest.” It will make an amount grow quicker than simple interest, which is calculated only on the principal sum.
Albert Einstein described compound interest as one of the world’s wonders – the eighth one, precisely. When one deposits an amount in a savings account or a related account, one will usually receive interest based on the amount. For instance, if one deposits $1,000 in a savings account that pays 5 percent annual interest, one would get $50 in interest after a year, resulting in a new balance of $1,050. Compound interest is interest that one earns on interest. So, in the above example, in year two, one would earn 5% on the larger balance of $1,050, which is $52.50—giving one a new balance of $1,102.50 at the end of year two.
Compound interest expedites interest earnings, helping one’s savings grow more quickly. As time passes, one will earn interest on ever-larger account balances that have grown with the help of interest earned in previous years. Over the long term, compound interest can cause interest earnings to snowball very quickly and help one build wealth. That means that one earns interest not only on one’s original deposit but also on the interest one accumulated during the first month.
The power of compounding interest shows why it is so important to stay invested in the market for a long time, through thick and thin. Successful investors do not try to time the market, nor do they fixate on instant gratification.
Compound Interest Example
A fresh graduate got lucky by getting employed at a telecommunication company. The pay was good, so he took the advice of a senior and finance-savvy colleague to invest some of his salary in an investment with compound interest. The finance-savvy colleague told him that compound interest could indeed turn meager funds into wealth over time. The graduate takes the advice and invests $50,000 at an annual interest rate of 5%, compounded monthly. If he keeps the investment for 10 years, his funds will be $80,235.05. On the other hand, if he went for a simple interest investment his money after 10 years will be $70,500.« Back to Glossary Index