⚠️ Disclaimer: For educational purposes only. Not financial advice. See full disclaimer.
The Difference Between Simple and Compound Interest
Simple interest is calculated only on the original principal. If you invest $1,000 at 10% simple interest, you earn $100 each year, forever.
Compound interest is calculated on the principal plus all accumulated interest. Your interest earns interest. This creates exponential growth.
The Math: How Powerful Is Compound Interest?
Let's compare two investors:
- Early Emma: Invests $5,000/year from age 25 to 35 (10 years), then stops. Total invested: $50,000
- Late Larry: Invests $5,000/year from age 35 to 65 (30 years). Total invested: $150,000
Assuming 7% average annual return (compounded annually):
- Emma at 65: ~$602,000
- Larry at 65: ~$472,000
Emma invested 3x less money but walked away with more wealth. This is the power of time and compound interest.
The Compound Interest Formula
A = P(1 + r/n)^(nt)
- A = Final amount
- P = Principal (initial investment)
- r = Annual interest rate (as a decimal)
- n = Number of times interest compounds per year
- t = Time in years
The Rule of 72
Want to quickly estimate how long it takes to double your money? Divide 72 by your interest rate:
- At 6% return: 72 ÷ 6 = 12 years to double
- At 9% return: 72 ÷ 9 = 8 years to double
- At 12% return: 72 ÷ 12 = 6 years to double
Where Does Compound Interest Work For You?
- Index funds and ETFs: Long-term stock market investing compounds returns over decades
- High-yield savings accounts: Better than standard savings, though rates vary
- Dividend reinvestment: Reinvesting dividends accelerates compounding
- Retirement accounts (401k, IRA): Tax advantages amplify compound growth
Where Compound Interest Works Against You
Compound interest is a double-edged sword. On debt — especially credit cards charging 20-30% APR — it works against you ferociously. A $5,000 credit card balance at 22% APR, paying only minimums, could take 20+ years and cost nearly $15,000 total to pay off.
Rule: eliminate high-interest debt before investing (except basic emergency fund and employer 401k match).
"Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it." — Often attributed to Albert Einstein
Key Takeaways
- Start investing as early as possible — time is your greatest asset
- Reinvest dividends and returns — let compounding do its work
- Pay off high-interest debt first — compound interest destroys wealth when it's on your liabilities
- Be patient — compound growth is slow at first, then suddenly spectacular
Conclusion
Compound interest is the most important financial concept you can learn. The earlier you understand and act on it, the wealthier you'll be. Even small amounts invested consistently over long periods can grow into life-changing sums.
Ready to put compound interest to work? Read our guides on Getting Started with Stocks and Budgeting for Beginners.