What is Compound Interest?
Compound interest is often termed as the ninth wonder of the world. It’s said that Einstein made that statement because of the sheer power of compound interest. If you paid attention in science class you remember the word exponential linked to bacterial growth. Compound interest works the same way.
The Difference Between Simple Interest and Compound Interest
Simple interest is pretty easy to understand. A 10% return on 100 dollars is 10 dollars. This means that if you deposit one hundred dollars in the bank at a ten percent simple rate of interest, your money will earn ten dollars. However compound interest is different.
How Does Interest Compound?
Interest compounds when interest is paid on interest. If a bank offers a 10% rate of interest that compounds annually, they are committing to pay 10% on your principal, or the initial deposit, each year. If you leave the interest paid in the account, the bank will pay 10% on the new principal and so now interest is being paid on interest paid. On the borrowing side, it is the reason the balance on your credit cards goes up so fast. If you don’t pay it off every month you will be paying interest on interest.
How to Calculate Compounding Interest
Compound interest is pretty easy to calculate once you understand the idea. The interest rate will be multiplied by itself over and over again for the number of years or periods you choose. To multiply the interest by itself you will just take the interest rate plus one then raise it to the exponent number of years/periods. Then you will take that number and multiply it by the initial deposit amount.
Calculation: Initial Deposit X 1+rate ^ #periods
Compounding Interest Calculator
Here is a really nice compound interest calculator that you can use to figure how much your principal will grow based on a certain interest rate.
Try out a few different interest rates and starting savings amounts. You will quickly see how long it could take you to get to a million dollars!
Compound Interest Calculator
The Best Thing About Compounding Interest
Compounding interest is the most exciting for me is that when used in a Roth IRA, I get to keep all of the interest tax free! And that’s how you retire with tax free money.