Compound interest is the interest earned on both the initial principal and the accumulated interest from previous periods. This creates exponential growth over time, making it one of the most powerful concepts in investing.
Compound Interest Formula
A = P(1 + r/n)^(nt)
Where: A = Future value, P = Principal, r = Annual interest rate, n = Compounding frequency, t = Time in years
Key Concepts
Principal
The initial amount of money invested or borrowed. This is the base amount that earns interest.
Interest Rate
The percentage rate at which interest is earned or charged, typically expressed annually.
Compounding Frequency
How often interest is calculated and added to the principal. More frequent compounding means faster growth.
Time Period
The length of time the money is invested. Compound interest works best over longer periods.
The Power of Compound Interest
Compound interest is often called the "eighth wonder of the world" because of its exponential growth:
- • Early years: Growth appears slow, mostly principal
- • Middle years: Interest starts to accelerate
- • Later years: Explosive growth, mostly interest
- • Rule of 72: Divide 72 by your interest rate to find doubling time
Regular Contributions
Adding regular contributions to compound interest creates even more powerful results:
- • Dollar-cost averaging: Invest regularly regardless of market conditions
- • Compound growth on contributions: Each contribution also earns interest
- • Habit formation: Regular investing becomes automatic
- • Time in market: More important than timing the market
Investment Strategies
- • Start early: Time is your greatest ally in compound interest
- • Invest consistently: Regular contributions amplify growth
- • Reinvest dividends: Let your earnings compound
- • Diversify: Spread risk across different investments
- • Stay invested: Avoid emotional decisions based on market fluctuations
- • Consider tax-advantaged accounts: IRAs, 401(k)s, etc.