Compound Interest

Compound interest is often called the "8th wonder of the world" because of its powerful ability to grow your money exponentially. Unlike simple interest, which pays you only on your original investment, compound interest pays you not just on your principal but also on all the interest that has already been added. This means your money begins to earn money, and that money earns even more money as time goes on. The longer you leave your investment untouched, the greater the effect of compounding. This is why time is your greatest ally when it comes to building wealth.

The formula for calculating compound interest is:

where:

• $A$ is the amount of money accumulated after n years, including interest;
• $P$ is the principal (the initial amount of money);
• $r$ is the annual interest rate (as a decimal);
• $n$ is the number of times that interest is compounded per year;
• $t$ is the number of years the money is invested.

To understand the impact of compound interest, consider two scenarios. In the first, you start investing early with a small amount. In the second, you wait and invest much more later. Suppose you invest $2,000 per year from age 22 to 32 (for 10 years) and then stop. Alternatively, you wait until age 32 and invest $2,000 per year for 33 years, until age 65. Assuming a 7% annual return, the person who started early will actually have more money at retirement, despite investing much less overall. This is because the money invested early had more time to grow and benefit from the exponential effect of compounding.

To understand the impact of compound interest, consider two scenarios:

• In the first, you start investing early with a small amount;
• In the second, you wait and invest much more later.

Suppose you invest 2,000 per year from age 22 to 32 (for 10 years) and then stop. Alternatively, you wait until age 32 and invest 2,000 per year for 33 years, until age 65. Assuming a 7% annual return, the person who started early will actually have more money at retirement, despite investing much less overall. This is because the money invested early had more time to grow and benefit from the exponential effect of compounding.