Understanding Compound Interest: The Eighth Wonder of the World
Compound interest is the interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods on a deposit or loan. Thought to have originated in 17th-century Italy, 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.
The Power of Time
The most critical factor in compounding is time. The earlier you start investing, even with small amounts, the more time your money has to grow exponentially. This is often referred to as the "snowball effect."
Key Terms You Should Know
Initial Principal
The starting amount of money you invest or have in your account before any contributions or interest.
Compounding Frequency
How often interest is calculated and added back to your balance (daily, monthly, quarterly, or annually).
Frequently Asked Questions
What is the difference between simple and compound interest? +
Simple interest is calculated only on the principal amount. Compound interest is calculated on the principal plus any interest already earned. Over time, compound interest grows much faster.
How does compounding frequency affect my savings? +
The more frequently interest is compounded, the higher your final balance will be. For example, daily compounding will result in slightly more money than monthly or annual compounding at the same interest rate.