What Is Compound Interest and Why It Is Either Your Greatest Ally or Your Worst Enemy

Albert Einstein allegedly called compound interest the eighth wonder of the world. Whether he actually said it or not the point is valid. Compound interest is the most powerful force in personal finance. It is also one of the least understood. This article explains exactly what it is, how it works for you when you are saving and against you when you are in debt, and what you need to do about it starting today.

The Simple Definition

Interest is what you earn on money you save or invest, or what you pay on money you borrow. Simple interest is calculated only on the original amount. If you invest $1,000 at 10 percent simple interest you earn $100 per year every year.

Compound interest is different. It calculates interest on the original amount plus all the interest you have already earned. So in year one you earn $100 on your $1,000. In year two you earn interest on $1,100. In year three on $1,210. And so on.

The number does not look dramatic at first. But give it time and it becomes extraordinary.

The Math That Changes Everything

Here is a real example that most people have never seen. Two people each invest $5,000 per year. Person A starts at age 25 and stops at 35. They invest for 10 years then never touch it. Person B starts at age 35 and invests every year until 65. They invest for 30 years.

Assuming 8 percent average annual return, by age 65 Person A has approximately $787,000 from just 10 years of investing. Person B has approximately $611,000 from 30 years of investing. Person A wins by $176,000 by doing less because they started earlier.

That is compound interest. Time is the most important ingredient. The earlier you start the less you have to invest to end up with more.

When Compound Interest Works Against You

Everything above applies in reverse when you are carrying debt. Credit card companies use compound interest the same way investment accounts do. The difference is they are the investor and you are paying the interest.

The average credit card interest rate in America is around 20 to 24 percent. On a $5,000 credit card balance at 22 percent interest paying only the minimum payment it will take you approximately 25 years to pay it off and you will pay over $10,000 in interest. You borrowed $5,000 and paid back $15,000.

That is the same mathematical force working in the opposite direction. The bank is getting richer from your compound interest payments every single month.

The Three Things You Must Do Right Now

First, if you are carrying high interest consumer debt you must prioritize eliminating it before almost any other financial goal. You cannot out-invest 22 percent interest. No investment consistently returns more than what you are paying in credit card interest. Pay it off.

Second, start investing as early as possible even if the amount feels small. Twenty-five dollars per week invested at 8 percent average return over 30 years grows to approximately $118,000. Time matters more than amount when it comes to compound interest.

Third, do not interrupt it. Compound interest works best when left alone. Pulling money out early resets the compounding. Keeping it invested and letting it compound is where the real wealth gets built.

A Word About Financial Education

Compound interest is taught in schools as a math concept. It is almost never taught as the personal finance tool that changes lives. If your school had taught you this the way it taught you algebra you would have started investing the day you got your first paycheck.

But nobody taught you. So you are learning it now. And now is better than never.

The second best time to start investing was yesterday. The best time is today.