Compound interest is the process where interest is earned not only on the initial amount of money invested (the principal) but also on the interest that has already been added. This creates exponential growth over time.
How It Works
If you invest $1,000 at 5% annual interest, after the first year you have $1,050. In the second year, interest is calculated on $1,050, not just the original $1,000, giving you $1,102.50. Over time, the effect snowballs, greatly increasing returns.
Why It Matters
- For investors: Compound interest accelerates wealth building in savings and investments.
- For borrowers: It can work against you, as debt with compounding interest grows quickly if unpaid.
Final Thoughts
Compound interest is often called the 'eighth wonder of the world.' Harnessing it through investing and avoiding it in debt is one of the most powerful principles in personal finance.