Let's Break It Down - Compound Interest

When it comes to personal finance, compound interest is one of the most important concepts, as it allows money to grow not only on the original amount invested but also on the interest it has already earned. Put simply, compound interest is interest earned on both the original amount of money and the previously earned interest.

Over long periods of time, this continued investment is able to make a significant difference over long periods of time. While the growth may seem small at first, repeated earning of interest on top of previous interest can cause savings and investments to grow much faster as time passes.

How Does Compound Interest Work?

In order to understand compound interest, imagine someone invests $1,000 into an account that earns 5% interest each year. After a year, the account would’ve earned $50, putting the total at $1,050. During the second year, instead of having the 5% be calculated on the initial $1,000, it is now calculated on the new $1,050, which results in $52.50 of interest.

Over time, the process continues as the amount of interest earned annually becomes large, with an increased balance. After 10 years at a 5% annual rate, the starting value of $1,000 would grow to around $1,629 without adding any additional money. The frequency of compounding also affects how quickly money grows. Interest is able to compound annually, monthly, or daily, depending on the account. Generally, more frequent compounding allows for money to grow slightly faster as interest is being added to the balance more often.

Starting Early

A major advantage of compound interest is time; the longer money remains invested, the more opportunities it has to earn interest on previous interest, which is why financial experts encourage people to save and invest as early as possible. One does not need $1,000 to start; even small contributions invested over many years can become significant.

Compound interest is important as it shows that time is just as valuable as money when trying to build wealth. Being able to start early gives savings and investments more time to grow, while delaying can mean losing years of potential compounding.

Compound interest isn’t a guarantee of investment profits, and returns may fluctuate based on the investment; however, the underlying principle is present: money that is able to earn returns generates additional returns of its own. Compound interest demonstrates why starting early, saving consistently, and allowing for money to remain invested has such a powerful effect on long term financial growth. What may start as a small amount may become significantly larger when time is provided for compounding.