Is Compound Interest as Magical as Everyone Says it is?

Everyone and their mother talks about compound interest, but what is it?

If you’ve heard finance people talk about compound interest, you’d think it cures every human problem ever created.

While it may not be that magical, it is still really important.

Let’s break it down in simple terms so we are all on the same page.

Compound interest is when interest earns interest. An example may be best.

Let's say you have an account with a bank that earns 1% interest every year. You put $100 dollars into the account on January 1. Come January 1 of the following year, your account now has $101 because it earned a dollar of interest. If you don’t touch the account for another year (and the bank is still giving you 1% interest) you would have $102.10. 

Why not just $102? 

The reason is because now your extra $1 (the interest you earned from year one) is now also earning interest ($1 earning 1% interest is $0.10).

Your interest is earning interest. 

Now let’s look at some bigger numbers. 

If you put $1,000 into an account earning 7% interest every year, and didn’t touch that account for 40 years, the ending balance 40 years later would be $14,974.46. That’s almost $14,000 more than you had to start! And you only put in $1,000!

Whether you fully grasp the concept or not is besides the point. The main takeaway is that compound interest has huge significance in the long-run.

The earlier you start, the more time your money has to compound. 

Let’s start earning interest on interest on interest.