Compound Interest
Interest earned on both the original principal and the accumulated interest from previous periods, producing exponential growth over time.
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Compound interest is interest earned not only on the original principal but also on the accumulated interest from previous periods. Each period the base grows, and each period that growth itself earns more, producing an exponential rather than linear curve. It is the mechanism behind every long-term investment outcome and the reason starting early is more important than starting big.
How it works
In a simple example, you invest a principal at an annual rate, compounded once a year. After year one, you have principal plus interest. In year two, the interest accrues on that new, larger balance, not on the original principal. The longer the horizon, the larger the contribution from compounding versus principal. The compounding frequency (yearly, monthly, daily) increases the effective return slightly, but the dominant variable is time, followed by rate, followed by contribution.
Why it matters
A 7% annual return doubles money roughly every ten years (the rule of 72: divide 72 by the rate). $10,000 invested at 7% becomes about $20,000 in ten years, $40,000 in twenty, $80,000 in thirty, $160,000 in forty. The first ten years add $10,000; the last ten add $80,000. This nonlinear shape is why investors who start at 22 with modest contributions usually end up wealthier than investors who start at 35 with much larger ones. Compounding rewards time, and time cannot be recovered.
Example
You invest $300/month from age 25 to 65 (40 years) at a 7% average annual return. Total contributed: $144,000. Final balance: roughly $787,000. A second person invests the same $300/month but starts at age 35 (30 years). Total contributed: $108,000. Final balance: roughly $367,000. The first person contributed only 33% more but ended with more than twice the wealth. The extra ten years did most of the work.
When to use it
- You are evaluating whether to start investing now or wait for a “better time”
- You are choosing between paying down low-interest debt and investing
- You are planning a long-term retirement or financial-independence target
- You are explaining to yourself why small early contributions matter
- You are comparing simple-interest savings products to compounding ones