Compound interest has the power to turn a modest investment into a lot of money over time.
Albert Einstein is often quoted as having said something to the effect that compound interest is the greatest wonder of the universe. It’s an urban legend, but it packs some punch!
In today’s episode, I want to tell you about the magic of compound interest.
We hear about compound interest all the time, but what is it really? Simply put, compound interest is interest you earn on your interest. And it’s a really important concept to understand, because compound interest has the power to turn a modest investment into a lot of money over time. So listen up.
Compound Interest Versus Simple Interest
There are two different types of interest: compound interest and simple interest.
With compound interest, the interest you earn goes to work for you and earns more interest. You earn interest on both your principal and your accrued interest. With simple interest, on the other hand, this isn’t the case: the interest you earn is not reinvested to earn more interest.
Take, for example, two people we’ll call Compound Connor and Simple Simon. Compound Connor invests $1,000 earning interest at 10% compounded monthly. Simple Simon also invests $1,000, but earns simple interest at 10%.
After one year, Simple Simon’s $1,000 has grown to $1,100, while Compound Connor’s $1,000 has grown to $1,104.71 OK, so what’s the big deal? That $4.71 difference is almost insignificant.
Well, here’s the thing: over time, the effect of compound interest is phenomenal – actually, it’s exponential. Fast forward 30 years. Compound Connor’s $1,000 investment has grown to almost $20,000, whereas Simple Simon’s has grown to only $4,000. Now, that’s a big difference.