Compound interest is one of the most powerful forces when it comes to investing. Albert Einstein even said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” - and he said it for good reason.
Compound interest is basically interest on interest. It is the result of obtaining interest on both the money you earn in addition to the money you have made from interest before - the interest is compounded. In terms of numbers, compound interest can significantly increase the worth of your investments over time. To help you better understand compound interest take a look at this graph produced when using the compound interest calculator on investor.gov:
The graph above displays what your money would look like if you initially invested $10,000 dollars and earned 10% on your money every year for 10 years. Because of compound interest, you would have more than doubled money over 10 years without doing anything! And this result is not unrealistic at all - since 1926 the S&P 500, a stock market index tracking the performance of 500 large traded companies, averaged a 10% increase every year. The way compound interest works is because after the first year, you would have received $11,000 (10% of $10,000). After the second year, you would have received the same 10% interest, except this time you are getting that 10% interest on $11,000 - resulting in $12,100 after year 2. To help you better understand this concept, the chart below displays what your money would look like after every year, for 10 years:
As you can see, after year 1 the money you earned from the previous year is part of how you return the year after - it just keeps growing; that is what makes compound interest so powerful.
To take advantage of compound interest, the earlier you invest your money in a growing asset, the better. There is a way where you can take full advantage of compound interest, and pay no taxes on the money you make - click here to learn more about that.