Compound interest is interest calculated on both the initial principal and the accumulated interest from previous periods. Unlike simple interest, compound interest allows your money to grow faster because you earn interest on your interest.
This powerful concept is the foundation of long-term investing and wealth building. It's often called the "eighth wonder of the world" because of its dramatic effect on growing investments over time.
The compound interest formula considers the principal, interest rate, time, and compounding frequency:
Where: A = Final amount, P = Principal, r = Annual interest rate (decimal), n = Compounding frequency per year, t = Time in years
Problem: You invest $10,000 at 5% annual interest, compounded monthly for 10 years. How much will you have?
Solution:
Simple interest is calculated only on the principal amount. Compound interest is calculated on the principal plus any accumulated interest, resulting in faster growth over time.
More frequent compounding means slightly higher returns. Daily compounding yields more than monthly, which yields more than annual compounding.
The Rule of 72 estimates how long it takes to double your money. Divide 72 by the interest rate. At 8% interest, your money doubles in about 9 years (72/8 = 9).