The Eighth Wonder of the World
Albert Einstein reportedly called compound interest the "eighth wonder of the world," adding, "He who understands it, earns it; he who doesn't, pays it." Compound interest is the interest you earn not only on your initial amount of money (the principal), but also on the accumulated interest from previous periods. In simple terms, it's "interest on interest," and it creates a snowball effect that can dramatically grow your savings over time. The two key ingredients for compounding are time and a consistent rate of return.
Imagine you invest $1,000 in an account with a 10% annual interest rate. After the first year, you will have earned $100 in interest, bringing your total to $1,100. In the second year, you don't just earn interest on the original $1,000; you earn it on the full $1,100. This means you earn $110 in interest, bringing your total to $1,210. While this might seem like a small difference initially, over decades, the growth becomes exponential. This is why financial advisors stress the importance of starting to save early, even with small amounts, to give your money the maximum amount of time to grow.
However, compounding is a double-edged sword. Just as it can powerfully grow your savings, it can also rapidly increase your debt. High-interest debt, such as from credit cards or payday loans, also uses compound interest. If you owe $1,000 on a credit card with a 20% annual interest rate and don't make payments, the amount you owe will quickly spiral. The interest is added to your debt, and you then start paying interest on the new, larger debt. Understanding this principle is fundamental to making smart financial decisions, whether that's investing for the future or avoiding the trap of high-interest debt.