Compound interest
InvestingDefinition
Compound interest is interest earned on both your original principal AND on all previously accumulated interest. It's the single most important concept in personal finance - Albert Einstein reportedly called it the eighth wonder of the world.
With simple interest, you earn the same dollar amount every year. With compound interest, the amount you earn grows each year because your base keeps getting larger. The difference is negligible in year 1 but becomes enormous over decades. This is why time in the market matters far more than timing the market.
The key variables are: principal (starting amount), rate of return, time, and frequency of compounding. Of these, TIME is the most powerful because of the exponential curve - the growth in years 20-30 dwarfs the growth in years 1-10, even though you're adding no new money.
Compounding also works against you with debt. Credit card interest compounds monthly, meaning you pay interest on interest. A $10,000 credit card balance at 24% APR left unpaid would grow to over $100,000 in 10 years.
With simple interest, you earn the same dollar amount every year. With compound interest, the amount you earn grows each year because your base keeps getting larger. The difference is negligible in year 1 but becomes enormous over decades. This is why time in the market matters far more than timing the market.
The key variables are: principal (starting amount), rate of return, time, and frequency of compounding. Of these, TIME is the most powerful because of the exponential curve - the growth in years 20-30 dwarfs the growth in years 1-10, even though you're adding no new money.
Compounding also works against you with debt. Credit card interest compounds monthly, meaning you pay interest on interest. A $10,000 credit card balance at 24% APR left unpaid would grow to over $100,000 in 10 years.
How it works
$10,000 at 8% - growth over time
$10K
$100K
Yr 051015202530
Formula
FV = PV × (1 + r)^n
Example
You invest $10,000 at 8% annual return and add nothing else:
• After 10 years: $21,589 (you earned $11,589)
• After 20 years: $46,610 (earned $36,610)
• After 30 years: $100,627 (earned $90,627)
Notice: you earned MORE in years 20-30 ($54,017) than in the entire first 20 years ($36,610). That's compound interest accelerating.
• After 10 years: $21,589 (you earned $11,589)
• After 20 years: $46,610 (earned $36,610)
• After 30 years: $100,627 (earned $90,627)
Notice: you earned MORE in years 20-30 ($54,017) than in the entire first 20 years ($36,610). That's compound interest accelerating.
Related tool
Open the compound tool on Arsenal.finance →