What Is Compound Interest? The Eighth Wonder of the World

In this post we'll be covering one of the key pieces building wealth called compound interest.  But what is compound interest?   Let's start with quote out there on the interwebs, and it’s usually attributed to Albert Einstein:  

What is compound interest

 

"Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.”

Albert Einstein ...maybe

Now, I don’t know if Einstein actually said that or not--but regardless of who said it, it’s the truth.  

Compound interest is powerful.  And the earlier you start to harness its power by putting your money to work for you, the better off you’ll be.

So what exactly is compound interest?

Simply put, compound interest is interest on an investment or liability that is calculated against the principal AND all previously accrued interest.  

So not only is your principal making money, in addition-- the money your principal made is ALSO making money.  That’s very cool stuff.

In case you were wondering....

The Standard & Poor's 500, aka the S&P 500, is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.


 Like any investment, it's size fluctuates constantly, and past performance doesn’t predict future results, but it is a strong indicator. Feel free to use another percentage if you like.

How does it work?

Let’s look at some examples. For the sake of easy math, assume you have $1 to invest in a fund that has averaged a 10% annual return over the past 90 years. It’ll be a few years until you’ll need it, so you might as well let it grow.


Example #1:  The Effect Of Compounding Interest On  $1

YEAR

PRINCIPAL INVESTMENT

ENDING BALANCE

One

$1.00

$1.10

Two

$0

$1.21

Three

$0

$1.33

Four

$0

$1.46

Five

$0

$1.61

Six

$0

$1.77

Seven

$0

$1.95

Ten

$0

$2.59

Twenty

$0

$6.73

Thirty

$0

$17.45

You’ll see the effects of compounding interest beginning  as early as year 2--and the magic really kicks after 10, 20, and 30 years.  

If you left that $1 in this investment for 30 years, as a result, with compound interest you would have $17.45.  

Sweet! 

And keep in mind, you didn’t contribute anything beyond the initial $1 investment.

Let’s see what would happen if you added just $1 per  year, or $30 over 30 years.


Example #2:  The Effect Of Compounding Interest On  $1 Invested Annually

YEAR

PRINCIPAL INVESTMENT

ENDING BALANCE

One

$1.00

$1.10

Two

$1.00

$2.31

Three

$1.00

$3.64

Four

$1.00

$5.10

Five

$1.00

$6.72

Six

$1.00

$8.49

Seven

$1.00

$10.44​​​​​​​

Ten

$1.00

$17.53

Twenty

$1.00

$63.00

Thirty

$1.00

$180.94

With compound interest, in 30 years, your investment would have grow to nearly $181 with just $30 of investment.

Want to hear the coolest part of all? You have this power at your fingertips RIGHT NOW!

Seriously. You can set up an investment account today, invest a few dollars in a S&P Index Fund, and leave it alone.  Compound interest will take care of the rest.

Now admittedly, this illustration oversimplifies the “how, when, and where” of investing, which I’ll cover in a greater detail in a future post. But it definitely covers the “why.”

The more time you have to allow for your balance to grow (say 10, 20 or 30 years) the less investment you need to make to see exponential returns.  

So which would you rather have?

Option A: $1 a year starting today

-or-

Option B: $181 in the future

I’m for B.

How do you get started?

First, you need free cash flow that you can invest, and the confidence that you can leave it invested. For that, you need a budget that works.

Therefore, the sooner you pay off debt and take control of your financial destiny, the sooner you can start investing and benefiting from the wonders of compound interest.

To help get rolling, I'd recommend starting with this guide for the basics of personal finance, which covers how to...

  • 1
    Get Organized and In Control
  • 2
    Get Protected From The Unexpected
  • 3
    Pay Off Your Debt
  • 4
    Invest For Your Future
  • 5
    Don't Stop Dreaming

Now that you know the answer to what is compound interest, are you ready to start investing?  The sooner you start investing, the longer you have to benefit from it's power to create the financial future you want.  

If you are already utilizing compound interest to your benefit, please share your motivating successes in the comments below!  Any tools, tips for others ready to start investing?

About the Author

Hello, I'm Ryan. Besides writing about personal finance my other passions include spending as much time as I can with my amazing family, running around my neighborhood, and continuing to refine my skills as a product manager. You can also follow me on twitter @TMPF_Ryan.

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