Compound interest is a phrase that gets thrown around a lot in personal finance circles. But a lot of people still don’t fully understand what it is and how it works.
In this post, we’re going to clear it up for you and provide an example so you can see the amazing real-world effects of compound interest on your finances.
What is compound interest?
Compound interest is when the earnings on your investment starting creating earnings of their own. I really like how Investopedia defines it.
. . . compound interest can be thought of as “interest on interest,” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.
When considering compound interest, there are three important factors that will determine how fast your money grows.
- Interest rate or the percentage of earnings you receive from your investment.
- Time invested or how long your money stays put.
- Compounding frequency or the number of times each year that your earnings are dolled out to you. The more often the better.
The thing about compound interest is that it has the power to make a very average earner very wealthy given enough time and the right investment choices. That’s why it’s so important to begin investing as early as you can.
To illustrate the power of “beginning young,” take a look at an example: