What is compound interest?

In simple words, compound interest is interest you earn on interest you’ve previously earned.

Understanding what compound interest is and the power it has is probably one of the most important lessons you can learn in personal finances. Not in vain Albert Einstein called compound interest the “most powerful force of the universe”. He also said that “Compound interest is the 8th wonder of the world” and that “He who understands it, earns it; he who doesn’t, pays it.”.

Einstein was a pretty smart guy, so in my opinion is totally worth it trying our best to understand a concept he described in such terms.

How can I get compound interests?

Compound interest is not a product a service that you bank offers, its not like a credit card that you sign up for, its simply a concept that can guide your investment decisions if you choose to follow Einstein’s advice.

How powerful is compound interest?

Imagine you put $1,000 into a savings account paying 10% annually (such a savings account probably doesn’t exist, but bear with me for the sake of keeping the numbers simple). This means on day 1 you put $1,000 into the account and forget about them for a year, you make no deposits or withdraws. On day 366 you’ll have $1,100 (your initial $1,000 + 10%).

So far so good, but what you choose to do now is what’s going to make real difference. You can choose to spend those $100 you earned, or to reinvest them.

Imagine you plan to keep this account open for 30 years. If every year you withdraw the $100 you earned the math is very simple:

                                   Principal        Interest

  • Year 1              $1,000             $100
  • Year 5              $1,000             $500
  • Year 10           $1,000             $1,000
  • Year 20           $1,000             $2,000
  • Year 30           $1,000             $3,000

So over a span of 30 years your $1,000 investment would have earned you $3,000.

You might think that’s not bad, but let’s take a look at the same scenario with the only difference that you choose to reinvest your interest every year instead of spending it.

                                    Principal             Interest

  • Year 1              $1,000                $100
  • Year 5              $1,000                $1,610
  • Year 10           $1,000                $2,593
  • Year 20           $1,000                $6,727
  • Year 30           $1,000                $17,449

That is how powerful compound interest is.

How long does it take for compound interest to work?

Compound interest follows an exponential pattern. This means that it’s power increases with time. If you are planning to invest some money for just a couple of years the power of compound interest is going to be much, much lower than if you invested that money for 10 years, 20 year, 30 years or more. The more you wait to exit the more power compound interest will have on your investment.

Conclusions about compound interest

You might have heard the sentence “its never too late to start”. Well the opposite is also true in this case, it’s never too early to start saving. The sooner you start saving and investing the sooner you’ll see a meaningful impact on your principal thanks to the power of compound interest.

Now don’t be discouraged if you are just learning about compound interest now and you haven’t been taking advantage of it so far. You can’t change the past, but you can certainly decide how you want to proceed from today on.

So if you haven’t already, start saving, investing and taking advantage of the power of compound interest today. If you don’t trust me, trust Einstein!