Understanding Compound Interest: The Key to Financial Growth

Colorful image of a money-covered sphere labeled "The Snowball Effect Wealth" with arrows and dollar symbols, set against a vibrant background.

Alleged eighth wonder of the world, compound interest is the method of automatically reinvesting the interest you have earned on your principal amount, earning you even more interest. Here is everything that you need to know about it:

What is Compound Interest?

Compound interest is the interest calculated on the principal amount as well as the accumulated interest. It is also popularly referred to as interest on interest. For example, if you were to invest $1000 in a bank with a 7% interest rate, you would earn $70 in the first year (accumulating the total to $1070). For the second year, the interest would not be calculated at $1000 but instead at the new total of $1070. So 7% interest on 1070$ would be $74.9, leading to a total sum of $1144.9 and so on.

The power of compounding helps a sum of money grow faster than if just simple interest were calculated on the principal alone. Compound interest has a big impact on both savings and debt. When you save or invest, it helps your money grow faster by adding interest not just on your principal amount but also on the interest you’ve already earned. Over time, this can lead to significant growth in your savings.

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

However, when it comes to debt, compound interest can work against you. It adds interest on both the original amount you owe and the interest that’s already built up, which can make paying off debt feel like an uphill battle.

How to Calculate Compound Interest: The Formula

A = final amount

P = initial principal balance

r = interest rate

n = number of times interest applied per time period

t = number of time periods elapsed

Rule of 72

The rule of 72 is a simple and practical tool used to estimate how your investment will grow over time. When you divide 72 by the investment rate on your investment, you will get the time period it will take for your principal amount to double in value.

Compound interest vs. Simple interest

Simple interest and compound interest work differently than each other. Simple interest is calculated only on the original principal amount throughout the investment period whereas compound interest is calculated on the original principal amount as well as interest earned. Simple interest causes a fixed amount of interest to be earned per year. On the other hand, compound interest causes an increase in the amount of interest per year. For example, in terms of simple interest, the $1,000 account balance that earns 7% annual interest would pay you $70 a year. The earned interest would not be added back into the principal. In year two, you would earn another $70 and so on.

Stacks of gold coins increase in height with an upward arrow, symbolizing growth. A plant and trees in the background convey prosperity. — Compound interest turns time into your greatest ally, making your money work for you, again and again

For the first few years, there is not much of a difference in the growth of investments with either type of interest, but compound interest investments are still better. A major difference between the two types of investments is seen in the long term.

Why Is Compound Interest Key to Wealth Building?

Compound interest is like your money working overtime for you. It doesn’t just grow on the amount you put in—it also grows on the interest it’s already earned, creating a snowball effect. The earlier you start and the longer you leave it, the bigger that snowball gets. Even small amounts can grow into something huge over time, and you don’t have to do much—it works quietly in the background. It’s one of the easiest ways to let time and patience work in your favor, turning consistent savings into long-term wealth.