According to Albert Einstein, the 8th wonder of the world is compound interest.
Understanding Compound Interest
Einstein is quoted as saying, "Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn't … pays it.” This emphasizes the significant impact compound interest can have on wealth accumulation.
What is Compound Interest?
Compound interest is interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods on a deposit or loan. In other words, it's "interest on interest."
The Power of Compounding:
The longer your money compounds, the more powerful the effect becomes. This principle is especially effective over long periods of time, such as retirement savings.
Example of Compound Interest
Here's a simplified example:
| Year | Starting Balance | Interest Rate (5%) | Interest Earned | Ending Balance |
|---|---|---|---|---|
| 1 | $1,000 | 5% | $50 | $1,050 |
| 2 | $1,050 | 5% | $52.50 | $1,102.50 |
| 3 | $1,102.50 | 5% | $55.13 | $1,157.63 |
As you can see, the amount of interest earned increases each year, even though the interest rate remains constant. This is the power of compounding.
