Compound Interest
Compound interest explained: how reinvested returns snowball over time, the rule of 72, and why compounding builds savings but deepens debt.
Compound interest is interest calculated on both the original sum and the interest already earned, so growth accelerates over time. A savings balance earning compound interest grows faster each year because every interest payment joins the principal and starts earning interest itself, unlike simple interest paid only on the original amount.
How compounding works
Imagine $1,000 earning 10 percent a year. With simple interest you would collect $100 every year — $1,500 after five years. With annual compounding, each year's interest joins the balance: $1,100 after year one, $1,210 after year two, and about $1,611 after five. The gap looks small at first, then explodes: after 20 years the simple-interest balance is $3,000 while the compounded balance exceeds $6,700.
The compounding frequency matters too: interest added monthly grows slightly faster than interest added yearly at the same headline rate, because each slice starts earning sooner. Banks quote an annual percentage yield precisely so savers can compare different frequencies fairly.
The rule of 72
A handy shortcut estimates doubling time: divide 72 by the annual rate. Money earning 6 percent doubles roughly every 12 years; at 8 percent, every 9 years. The rule works because 72 has many divisors and closely approximates the mathematics of exponential growth at everyday rates.
Run it backwards and it explains fortunes. An investment compounding at 7 percent for 40 years multiplies roughly fifteen-fold, which is why starting early beats saving more later: money invested at 25 has far longer to double and redouble than money invested at 45. Every year of delay carries a real opportunity cost in forgone growth.
Compounding in saving and investing
Retirement accounts are compounding's natural home: decades of reinvested dividends and gains snowball inside pensions and index funds while fresh contributions keep feeding the principal. Reinvesting rather than spending payouts is what keeps the snowball rolling — each dividend buys assets that earn their own returns.
But nominal growth is not real wealth. If savings earn 4 percent while prices rise 3 percent, purchasing power grows only about 1 percent a year. Inflation quietly compounds against you, which is why investors compare returns after subtracting it — and why cash left idle steadily melts.
The dark side: compound debt
Compounding is indifferent to whose side it serves. Unpaid credit-card balances compound monthly at rates that can exceed 20 percent a year, so a debt left alone doubles in under four years. Minimum payments stretch the loan out, letting interest pile upon interest — the mirror image of a growing pension.
Knowing this rarely feels urgent, which is the trap: present bias makes today's spending vivid and future interest abstract. One defence is to keep separate mental pots for saving and spending — the deliberate use of mental accounting — and to automate transfers so compounding works for you before temptation can spend it.