What is Compound Interest?

Compound interest is a fundamental component of wealth creation and you need to understand it in order to take advantage of it, as well as to ensure it doesn’t take advantage of you.

What do I mean by this?

Albert Einstein stated that “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

Albert Einstein on Compound Interest

If Einstein is so impressed by it, it’s certainly worth talking about.

First, what is Interest?

Let’s start with the word interest. Interest is the amount someone either pays or receives for borrowing or lending money. You wouldn’t give someone something of value and tell them to pay you back whenever without getting a kick-back in return. In the financial world, borrowing or lending money will usually generate some amount of interest to be paid or received – depending on if you’re the one borrowing or lending the money.

The amount of interest is calculated using an interest rate, usually expressed on a per year basis. This is a percentage amount that is calculated from the amount being borrowed or lent out. These can vary wildly depending on the risk of the deal, time-span, amount, urgency, industry as well as who you are as a person and how trust-worthy you’ve been with other people’s money before (Hint: Credit history!).

Further, the amount of interest is also determined by the amount of value of the principal being loaned or borrowed.

Furthermore, the term (duration) of the loan will also impact the interest amount owed. For example, if it is a 1 year, 5 year or 30 year loan.

So to recap, interest is a fee payed or received on money borrowed or lent, and the interest amount is calculated based on a percentage amount off the principal value of the deal & loan term.

Making sense? If not, don’t worry. This next part should start to clarify things for you.

Simple Interest vs Compound Interest

There are two primary ways interest is calculated. These are called simple interest or compound interest.

Simple Interest

Simple interest is where interest is only earned on the principal amount for the life of the deal.

As an example, let’s say you put $1,000 in a one year term deposit that will pay you simple interest at completion – which means you are lending your money to the bank for a year. They will offer to pay you 2% in interest per year.

After that one year, you’ll get your initial deposit back and your 2% interest which means in total you will received $1,020, made up of your initial $1,000 and $20 in interest earned.

If you want to know how it works from the borrower’s side; consider being in the bank’s shoes for this example. You’d borrow $1,000 and have to pay the full amount back plus an extra $20 in interest at the end of the term. Not bad right? But it could be better. That is where compound interest is king.

Compound Interest

Compound interest means you generate interest on both your principal amount and your added interest at certain compounding intervals. This means that the interest you earn is added to the principal amount, and that new amount can begin earning (or costing) even more interest.

Let’s take the same example as before of $1,000 at 2% per year over one year. But this time, our deal is using compound interest that compounds every month.

At the end of the year, you’d get $1,020.18. Because every month, the current interest owing was calculated and added to your principal, so that then in the second month when the calculation was done again, the interest earned was slightly higher because the previous interest was also included in the calculation.

The amount earned in this simple example might not sound that different, but the true power of compound interest comes over time, as the additional amount earned from the interest portion becomes more and more prominent. The graph below will illustrate the extreme difference over time.

compound interest graph
Compound Interest vs Simple Interest over time

So why did Einstein say that he who doesn’t understand compound interest pays it? Well, much like it can work to your benefit when compounding money you invest over an extended period of time. It can also work against you when it is being used on money you owe, such as a credit card with an outstanding balance. This means that the longer you take to pay it off, the more aggressively your debt increases over time because the interest portion is working against you and not for you.

What do I want you to take away from this?

Essentially, compound interest is really cool, when you know what it can do. If you want to get ahead financially, be sure to invest your money as early as you can and as consistently as you can because over time you will be rewarded as compound interest catapults your investments far quicker than you can save on your own.

On the flip side, be very careful when borrowing money. Make sure you understand that the longer you take to pay it off, when calculated with compound interest, the faster your debt owing will grow. So in most cases, you want to avoid debt and pay them down as quickly as possible. That is of course you are familiar with good debt vs bad debt, which is a topic for another video.

Alex O'Donnell

I'm a 20-something IT professional by day with a strong passion for finance, investing, cars, motorbikes and music. Living in Sydney, Australia.

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