You might have heard about compound interest and sure, you know, it's good for your investments. But, what exactly is it?
Compound interest (or compounding interest) is interest calculated on the initial principal and which also includes all of the accumulated interest of previous periods of a deposit or loan.
The best way to understand how compound interest works is with examples. So let's work some numbers. Imagine that you invest $1,000 and that your expected return rate is 5% per year. If you leave your money invested for 10 years at the end, you would have $1,500 dollars.
Now, let's look at the same $1,000 dollars at the same expected return rate of 5% percent but this time we'll add compound interest over the course of 10 years. At the end, your balance would be $1,630 dollars, which is an additional $130 dollars.
Where did the bigger return come from?
Well with compound interest your earnings get reinvested. So you earn a interest, on your own interest. Time is your best ally. So to prove it, let's go back to the example and see your results over the course of 35 years instead of 10. Without compound interest, the $1,000 will grow into $2,750. But with compound interest, the same $1,000 dollars with an expected return rate of 5 percent will grow into $5,510 dollars.