Compound Interest
Compound interest occurs when the interest you’ve earned itself begins to earn interest. In other words, you don’t just receive returns on your original investment—you also earn “interest on interest,” which accelerates your overall growth.
Here’s how it works in practice:
- Initial investment (principal): The starting amount you invest.
- Interest period: At the end of each period (e.g., monthly or annually), interest is calculated on the current balance (principal + all previously earned interest).
- Reinvestment: That interest is added to your balance, so the next period’s interest is calculated on a slightly larger amount.
Over time, this compounding effect produces exponential growth, unlike simple interest, which only pays on your original principal and grows linearly.
Example:
Suppose you invest $1,000 at an annual interest rate of 8%, compounded once per year. After one year, you earn $80 in interest, bringing your balance to $1,080. The next year, you earn 8% on $1,080 (which is $86.40), so your balance rises to $1,166.40. If you let it compound for 10 years without adding any more money, you end up with about $2,159—more than double your original investment—all thanks to compound interest.
Compound interest can work against you, too: when you borrow at a high rate, your debt can grow very quickly if unpaid interest is continually added to your balance. That’s why understanding how compounding periods and rates affect both investments and loans is crucial for long-term financial health.
