What Is Compound Interest?
Compound Interest is interest on interest. What does that even mean!? When investing, compound interest is when money earns a return on investment and those returns are kept inside the investment so they can continue to grow too. It’s like placing a bet and if you win letting your winnings ride!
How is compound interest different compared to simple interest? With simple interest, returns are calculated only on the initial amount invested. For simple interest, any investment returns are removed (withdrawn or moved elsewhere) whenever they are earned rather than allowing them to be reinvested.
Compounding can be very powerful, especially over long periods of time. If anyone has ever told you to start saving early, compound interest is the reason why. For long-term investing, the sooner you begin to save the more time your investment returns can compound.
The power of compounding can also work against you with regard to interest on debt especially when higher interest rates are involved. The quote from Albert Einstein captures this best: “Compound interest is the eighth wonder of the world. He who understands it, earns it … He who doesn’t … pays it.”