How Compound Interest Works
Compound interest is often called the "eighth wonder of the world." It's the process where the interest you earn also earns interest, creating a snowball effect that accelerates your wealth growth over time.
The Compound Interest Formula
A = P(1 + r/n)^(nt)
Where:
- A = Final amount
- P = Initial principal
- r = Annual interest rate (decimal)
- n = Number of times interest compounds per year
- t = Number of years
The Power of Starting Early
Time is the most important factor in compound interest. Consider two investors: one starts at age 25 contributing $500/month, and another starts at 35 contributing $500/month. By age 65, assuming 7% annual returns, the early starter has about $1.2 million while the late starter has about $567,000 — nearly half as much, despite only contributing 10 more years.
Tips to Maximize Compound Interest
- Start early — Even small amounts grow significantly over decades
- Be consistent — Regular contributions amplify the compounding effect
- Reinvest returns — Reinvesting dividends and interest accelerates growth
- Minimize fees — High fees eat into your compounding. Choose low-cost index funds
- Be patient — Compounding is slow at first but accelerates dramatically over time