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Back to Basics: The Power of Compound Interest Thumbnail

Back to Basics: The Power of Compound Interest

Investment

Compound interest has been dubbed the "eighth wonder of the world" by Albert Einstein. 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 luminaries, 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 result in more robust growth in your investment portfolio. 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

As noted, there are many advantages when compound interest is calculated in your favor. It's also important to remember that not every investment will provide an opportunity for significant growth. As always, it is important to evaluate investment opportunities in the context of your overall goals, investment objectives and risk comfort level.

  1. https://www.forbes.com/advisor/investing/compound-interest/
  2. https://www.fool.com/investing/how-to-invest/stocks/compound-interest/

This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.

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