Compound Interest Broken Down

"Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it. " - Albert Einstein

Confused as to what compound interest really consists of? You're not alone. We aim to help bring some clarity to the subject.

What is compound interest? Compound interest is interest generated not only from an initial investment, but also on the interest it accumulates. More simply put, it is earning interest on interest. An initial investment will grow faster with compound interest than one with simple interest. This is because simple interest only generates interest based on the initial principal.

How is compound interest calculated? Compound interest is calculated by the total amount of principal AND the future value of the interest it will generate, minus the present value of the principal. Essentially, what the principal with interest will be worth in the future, less what your principal is valued at in the present. More technically:

Compound interest = [P(1+i)n] - P

Where P = the principal investment, i = interest rate, & n = the number of compounding periods

How can it help me? When investing, compounding interest is your friend. Investing a large principal amount when you have time to watch it grow can yield a great amount of wealth. If you can, make the compounding periods more frequent, such as semi-annually or even quarterly. Compound interest collects exponentially, so seizing opportunities to invest is key.

Is there a downside? Unfortunately, compound interest can work against you as well. If you have loan with high interest rates, such as credit card debt that compounds each month, you can end up paying an excessive amount of interest.