Compound Interest Explained: What is it and Why Should YOU Care?

Compound interest is one of the most powerful concepts in the world of finance. However, most people don't start early enough in life to take full advantage of it.

The idea of compounding is pretty simple: You invest money at a set rate over a given period of time and the earnings from that investment continue to accumulate at a set rate for the duration of the original period plus any additional period afterward.

That's why we call it "compound" interest—the earnings on your initial investment keep growing as time passes.

What Is Compound Interest?

Compound interest is the earning of interest, not only on the principal, but also on the accumulated interest. While simple interest is calculated only on the principal amount, compound interest is calculated on the entire principal and the accumulated interest. This means that the principal amount increases with the addition of previous interest amounts, so the more interest that is accumulated, the larger the principal sum becomes.

How Does Compound Interest Work?

In Economics, compound interest is any interest that is earned not only on the principal, but on previously earned interest as well. For example, interest on interest is how banks make the majority of their profits. It is a source of endless and exponential growth. Think of money in the bank as being invested in a business.

The bank is paying you in order to use your money, in essence compensating you for being able to use your money. You don’t get anything for free. However, the return on your bank account can be substantial. The greater the time value of money, the more interest will accumulate.

Why You Should Care About Compound Interest

You should care about compound interest because it can make a huge difference in the amount of money you have saved. You see, the earlier you start investing, the more time your money has to grow. That's why experts often say that compound interest is the eighth wonder of the world. If you start investing money at a young age (say, in your 20s or 30s), compound interest can really work in your favor.

It can help you save more money, allow you to retire early, and give you more financial security. But if you start investing money at a later age (40s and 50s), compound interest can still work in your favor. It just won't work quite as well. That's why it's so important to start saving money as early as you can so that compound interest has plenty of time to work its magic.

How to Take Advantage of Compound Interest

The best way to take advantage of compound interest is to start saving money as early as possible. The earlier you start investing money through things like a 401(k) or an IRA account, the more time compound interest has to work its magic and help you build wealth. You should make it a priority to save as much money as possible.

The more money you save, the more earnings will compound. And you should diversify your investments so that if one investment goes belly up, it doesn't cause you to lose all of your money. Finally, you should also be sure to leave your money alone. Don't touch that money! It will make compound interest work even harder in your favor.

How to Calculate Compound Interest

In order to calculate compound interest, you must first determine the amount of time you will be investing your money. Once you have that time period, you add one additional year to it. That will represent the total amount of time your investments will be growing. Then, you must determine the rate of return you will be earning on your money. That rate of return will also be added to the original amount of money you are investing. You would then take one final step to calculate the amount of money your investments will earn.

You would take the amount of money you are initially investing and multiply it by the total amount of time your investments will grow plus the rate of return you are earning. That would be the total amount of money your investments will earn after a given period of time.

Conclusion

Compound interest is a powerful force that can help you build wealth over time if you let it. The earlier you start investing money, the more time compound interest has to work in your favor. The best way to take advantage of compound interest is to start saving money as early as possible and to diversify your investments so that if one investment doesn't work out, it doesn't cause you to lose all of your money.

Want to calculate compound interest and see how it works for you? Check out our free compound interest calculator to see the compounding effect on your savings over time.

We hope that you found this guide helpful in understanding how compound interest works.