Compound interest is known as "interest on interest". Unlike simple interest, where the return is calculated only on the initial amount, in compound interest the return is calculated on the accumulated value.
The compound interest formula
A = P × (1 + r)^tA = P × (1 + r)^t, where A is the final amount, P is the principal, r is the interest rate and t is the time.
Practical example
If you invest $10,000 at 1% per month for 12 months:
Simple interest
Simple interest: $10,000 + ($10,000 × 1% × 12) = $11,200
Compound interest
Compound interest: $10,000 × (1.01)^12 = $11,268.25
Difference: $68.25 more with compound interest
The power of time
The longer the term, the greater the difference between simple and compound interest. In 10 years, $10,000 at 1% per month becomes $33,003.87 with compound interest, but only $22,000 with simple interest.
How to leverage compound interest
- Start investing as early as possible
- Reinvest the returns
- Maintain consistency in contributions
- Avoid unnecessary withdrawals