Compound interest has been dubbed the “eighth wonder of the world.” Benjamin Franklin held a similar fascination with compound interest, using it to create endowments for the cities of Boston and Philadelphia that are still paying out. What is it about compound interest that drew the attention of these geniuses, and what separates it from other forms of interest?
Simple interest only generates interest on the principal. In other words, if you had $1,000 in an account and it generated $50 of interest over a year, it would only yield another $50 the next year because it’s only earning interest based on that initial $1,000 deposit (a.k.a., the principal). Compound interest, on the other hand, generates interest on both the principal and any interest earned over time.(1)
While that’s great for your savings or checking account, compound interest can also play rough. One example of this that many can relate to is credit card debt. This kind of debt is also calculated with compound interest, but only in favor of the company providing you with the line of credit. As the debt grows and interest is added, the interest is calculated on the total amount you owe, not merely on the initial amount you purchased.
In some cases, compound interest can take your investment further. For example, if you had $20,000 and divided it among two investments—one offering 10% simple interest and the other offering 10% compound interest—you’d see far greater returns over the next three decades with the compound interest investment. The investment offering simple interest would earn you an additional $30,000 over that 30-year period. Meanwhile, the compound interest would earn you an additional $164,494.(2)
While there are many advantages when compound interest is calculated in your favor, it’s also important to remember that not every investment opportunity will provide this option. For this reason, it’s important to keep your eye out for these opportunities when they arise.