How Compound Interest Works

Corey —  January 12, 2010

       To get a small fortune, you have two options:

  1. Start with a large fortune.

  3. Use the power of compound interest (or returns).

       I don’t have any good tips on how to start life with a large fortune, but I can tell you about compounding and how it works.

Simple Interest

       First, you need to understand simple interest. Simple interest is just a flat interest rate paid only on your initial deposit year after year. Let’s say you’ve got a bond that pays you 8% simple interest. If you buy $100 worth of that bond, you’ll get $8 in interest for the first year. Then, because this is simple interest, you’re going to get $8 in interest every year after that until the bond is repaid (and you get your original $100 back). Here’s what it looks like on a chart:

       With simple interest, you’re only earning interest on your principal (or your deposit). You’ll get $8 every single year. You never earn interest on interest. At the end of 20 years, you’ll have your initial $100 plus $160 you earned from interest.

Compound Interest

       Compound interest lets you earn interest on your principal (what you start out with), but you also earn interest on interest you’ve already been paid. We’ll keep the same assumptions as before – you earn 8% interest and you start out with $100 – but this time we’ll be using compound interest.

       At the end of the first year, you’ll still only earn $8 in interest ($100 * 0.08). But at the end of the second year, you’ll earn a total of $8.64 in interest ($100 * 0.08 + $8 * 0.08). In the third year, you’ll earn $9.33 in interest ($100 * 0.08 + $8 * 0.08 + $8.64 * 0.08). This process keeps continuing and you keep earning more and more interest every year. Here’s what it looks like on a chart:

       Compound interest is all about earning interest on interest (and principal). You’re generating earnings from previous earnings. In the example above, you’d have your initial $100 plus $366.10 in interest at the end of 20 years. That’s $206.10 more than what you’d get from simple interest. The only difference between the two is the ability to earn interest on interest.

       Compounding is why it pays to start saving as early as possible. In the first year, you may only get an extra $0.64. But in the twentieth year, compound interest gives you an extra $26.43. The amount of interest you earn on previous interest just keeps growing and growing the longer you go.

       Let’s look at a quick example. Let’s say we have three people who are all going to invest for retirement. They’re all 25 years old, and they’re all looking to retire at age 65. They’re all going to invest $25,000 at one time, but they start at different times. Sue invests her $25,000 today, Bob invests his $25,000 ten years later, and Frank invests his $25,000 ten years after Bob. To keep it simple, we’ll assume they earn 8% every year. Here’s what happens:

       Sue only started ten years before Bob, but she ended up with over $290,000 more than he did. Likewise, Bob started only ten years before Frank, but he ended up with over $135,000 more. The only difference between these three people was how many years they let their money compound. Sue had 40 years, Bob had 30 years, and Frank only had 20 years. Compounding has the most power when you have the most time. That’s why it’s important to start saving early (not just for retirement, but for any goal).

Your Thoughts

       Did these examples help you better understand compound interest? If not, what questions do you still have? Let me know in the comments and I’ll do my best to help you and give a clearer answer.


