Albert Einstein once said “Compound interest is the 8th wonder of the world. He who understands it, earns it…he who doesn’t, pays it.” So let’s see what makes it so great?

Remember, it’s always important to make long-term projections in order to maximise rewards.

First, we need to make a difference between simple interest and compound interest.

Simple Interest

If you put 1,000$ dollars in an account earning let’s say 5% annually, that means each and every year you’ll be making 50$/year. Here is how it’d look like.

 

Now, let’s do some simple math. 1,000$ plus 50$ for the first year and then 50$ for the 2nd year and 50$ for the third year, and so on and so on. As a result, 1000$ in 10 years will have grown to 1500$. That’s right.

But wait a second, what about compound interest, how is that different?

Compound Interest

Now, let’s take the same 1000$ at 5% annual earning, but this time around we’ll be using compound interest.

So in the first year, you earn $50 in interest just like in our simple interest example. But in the second year that interest is added to the original principal amount. So in year two, you earn 5% on 1,050$ which is $52.50. Now your total is 1,102.50$. In year three you earn 5% on this new amount which is 55.13$. If we fast forward to the 10 years mark, you will have a total of $1,628.89.

A difference of 128.68$ over 10 years is a paltry amount, but this is just a small example. Let’s expand the example to a $10,000 retirement investment over 40 years of working life. With simple interest, the final sum is 30,000$, but with compounding interest, the final amount is $70,399.89. That’s over $40,000 more.

It’s important to note that these examples don’t include any amounts that you add to your investment over time. The more you add and the more frequently you do so, the more interest you will earn over time.

So, Einstein was a pretty smart guy and knew what he was talking about when he called compound interest the 8th wonder of the world.