A wise man once said, “Compound interest is the eighth wonder of the world. He who understand it, earns it… He who doesn’t, pays it.” That man was Albert Einstein.
Compound interest might be compound, but it’s not complex. To help you understand compound interest, let’s take a look at how simple interest works.
Let’s assume you have 100 dollars in a savings account, earning 5 percent simple interest. Each year, your balance increases by 5 percent of that initial principal. In other words, your account balance grows by five dollars per year.
Now let’s use the same scenario, but put that money in an account earning compound interest. Each year, the interest earned is added to the principal, and then interest accumulates on the entire amount. In other words, you’re earning interest on your interest!
The difference is a steady growth of your account balance, versus growth at an ever-increasing rate.
The beauty of compound interest really reveals itself over time. Using the above example, let’s take a look at what would happen after thirty years. In the simple interest account, you would have accumulated 250 dollars. But in the compound interest account, over the same period of time, you would now have $432.19. That’s 73 percent more money!
As you can see, compound interest can be your best friend if it’s working for you. But it can be your worst enemy when it’s working against you, such as when you pay compound interest on credit cards.
As it turns out, that Einstein guy knew what he was talking about!