A Simple Guide to Compound Interest
How does wealth grow over time? The answer is often surprisingly simple: compound interest.
It’s understood that your late teens and early twenties come with many expenses on a limited income. Still, this is an ideal time to start taking advantage of compounding. Even small balances can grow significantly over time if you give them enough time.
What Is Compound Interest?
Compound interest, from a savings and investment perspective, occurs when you earn interest on your interest. Instead of just earning a return on your original principal, which is called simple interest, this “interest on interest” effect becomes a major factor in long-term growth over time.
Simple vs. Compound Interest: A Quick Example
Scenario #1: Let’s say you invest $25,000 at 6% simple interest for three years. You’d earn:
$1,500 each year
$4,500 total after three (3) years
Scenario #2: Now take the same $25,000 at 6% compounded annually:
Year 1 interest: $1,500
Year 2 interest: 6% of $26,500 = $1,590
Total interest earned: $4,775; total account balance: $29,775.
As you can see, compound interest in scenario #2 earned more money than simple interest, and the difference increases over longer periods.
Compounding Happens at Different Speeds
Interest doesn’t always compound once a year. It can compound:
daily
monthly
quarterly
semi-annually
Note: The more often interest compounds on savings, the faster your money grows. But remember, loans require you to pay interest, so the more frequent the compounding, the more interest you owe.
The Rule of 72: A Quick Shortcut
If you're looking for a quick way to estimate how long it takes for money to double with compound interest, use this simple formula: 72 ÷ interest rate = years to double.
For example:
At 8%, your money may double in about 9 years (72 ÷ 8 = 9).
Want to know how long it takes to triple? Use: 115 ÷ interest rate = years to triple
Try different rates to see how dramatically time and growth work together.
Another Example
Say you invest just $50 a month starting at age 20, earning 7% annually. By age 40, you will have contributed $12,000. However, thanks to compounding, your balance would be around $26,000. This is a classic example of your money working for you.
Bottom Line
Although compound interest is a powerful way to build wealth, it takes time to be effective. Start small, stay consistent, and let compounding do its thing.
Disclaimer: Creek & Lyells Financial Literacy Foundation does not provide financial services, nor does it recommend or advise visitors to open accounts or buy or sell securities. All content on this blog is for educational purposes only. While we strive to provide accurate, relevant, and well-vetted information, visitors should consult a licensed financial professional and carefully evaluate the risks of any financial decision before taking action.