Here’s how compound interest works:
Initial Investment: You start by investing a certain amount of money, let’s say $1,000, into an investment vehicle like a savings account, bond, or stock.
Interest Earning: Over time, your investment earns interest based on the applicable interest rate. This interest is added to your initial investment, effectively increasing the total amount of money in your account.
Compounding Periods: Compound interest can be compounded at different intervals, such as annually, semi-annually, quarterly, or even daily, depending on the investment or financial product. The more frequently your interest is compounded, the faster your investment grows.
Accumulation Over Time: As time passes, the interest earned on your investment continues to accumulate, not just on the initial principal amount but also on the previously earned interest.
Exponential Growth: The magic of compound interest lies in its exponential growth effect. Over longer periods, the interest you earn on your investment can become a significant portion of your total account balance. This means your money can grow faster and faster as time goes on.
Compound interest is often described as the “eighth wonder of the world” because of its ability to significantly increase wealth over time, especially when investments are left to grow for long periods. It emphasizes the importance of starting to invest early and regularly contributing to your investments to take full advantage of the compounding effect.
For example, if you invest $1,000 at an annual interest rate of 5%, compounded annually, after one year, you’ll have $1,050. In the second year, you’ll earn interest not just on the initial $1,000 but also on the $50 of interest earned in the first year. This cycle continues, leading to exponential growth in your investment over time.
