What is Compound Interest? Learn The Magic of Exponential Growth

Have you ever wondered how your money can grow from the thousands to the millions? Enter compound interest – the financial superpower that can turn modest investments into significant long-term wealth. So, what is compound interest, and how can it help you make that financial leap to accelerate your path to wealth? This article will cover the magical force behind compound interest, demonstrate the difference between simple and compound interest and help you see how it can accelerate your financial future.

Simple and Compound Interest

Let’s back up a second before we discuss the answer to “What is compound interest?” There are actually two different kinds of interest you need to understand: simple and compound interest. When saving or investing, they both provide some growth on your money over time, but compound interest can significantly accelerate that growth, making your timeline toward your goal happen much sooner!

It is important to understand that interest can work for you and against you. It works in your favour when you save or invest, and it definitely works against you when you borrow or owe money—as anyone who has ever carried a credit card balance can attest to! So, let’s learn a bit more about simple and compound interest.

What Is Simple Interest?

Simple interest is calculated based only on the initial amount of a loan or savings. Interest does not build on the interest that you owe or earn. 

What Is Compound Interest?

Now, compound interest is where your interest earned starts to earn its own interest! You earn interest not just on your initial investment but also on the accumulated interest over time. Hence, it provides a compounding effect, building interest on top of interest, creating a snowball effect that significantly boosts earnings.

Compound Interest Example 1: The Power Of Starting Early

Meet Emily and Tom, two friends with different investment strategies. Emily begins investing $1,000 annually in an account at age 25, earning a steady 7% interest. She stops at 35 after investing a total of $10,000.

Tom decides to wait and starts investing the same amount as Emily, starting at age 35 and continuing until he’s 65, investing a total of $30,000.

Result: Despite investing more, Tom has significantly less than Emily by age 65. Due to Emily’s early start, her investments have had more time to grow due to the magic of compound interest. Emily’s account could potentially reach the millions, whereas Tom’s falls substantially short.

Compound Interest Example 2: The Impact Of Reinvesting Earnings

Consider someone who invests a lump sum of $100,000 at an annual interest rate of 8%. While investing, they reinvest all of their earnings back into the investment account and do not withdraw anything.

• After 10 years: They will have approximately $215,892
• After 20 years: They will have around $466,097
• After 30 years: They will have about $1,006,266

By reinvesting your earnings, your investment grows exponentially over time, showcasing the incredible potential of compound interest. The difference between withdrawing dividends and interest and reinvesting those earnings could lead to reaching a million-dollar portfolio and beyond.

Harnessing the Power of Time and Consistency

The strength of compound interest lies in time and consistency. Starting to invest early and remaining invested for the long term can significantly boost your investment potential allowing your investments to reap the benefits of compound interest.

In summary, while investing carries risks, and returns are never guaranteed, leveraging compound interest by starting early and staying committed could lead to substantial financial growth, potentially helping you reach incredible financial milestones.

Remember, the examples here illustrate the concept and may not reflect actual investment results. To help you understand how your investment can grow with compound interest, we created a Retirement Calculator to help you do that!