Written by Matthew Brooks
Compound interest is when your money makes money, and then that money makes MORE money. It's the closest thing to magic in finance.
You invest $10,000 at 8% annual return. After year one, you have $10,800 (you earned $800). But in year two, you don't just earn 8% on your original $10,000 - you earn 8% on $10,800, giving you $11,664. That extra $64 is compound interest - you're earning returns on your returns.
You turned $10,000 into over $100,000 without adding a single extra dollar. That's compound interest at work.
It works in reverse too. Credit card debt at 22% compounds against you, which is why a $5,000 balance can balloon into $10,000 if you only make minimum payments.
Einstein allegedly said: "Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it."
Start investing early. Thanks to compound interest, someone who invests $500/month starting at age 25 will have more at 65 than someone who invests $1,000/month starting at age 45.
See compound interest in action with our Compound Interest Calculator!