What Is Compound Interest and How Does It Build Wealth?

Compound interest is the concept of earning interest on your interest. It is the foundational mathematical principle behind wealth accumulation and retirement planning.

Simple Interest vs. Compound Interest

To understand compound interest, we first must understand simple interest.

If you invest $1,000 at a 5% simple annual interest rate, you will earn $50 every year. After 10 years, you will have made $500 in interest.

However, with compound interest, the interest you earn in the first year gets added to your principal. In the second year, you earn 5% on $1,050, not $1,000. This creates an exponential growth curve.

The Power of Time

Because the growth is exponential, the most critical factor in compound interest is time.

Let's look at an example. If you start investing $500 a month at age 25, assuming an 8% annual return, you will have over $1.7 million by age 65.

If you wait until age 35 to start investing the exact same amount, you will only have about $745,000 by age 65. A 10-year delay costs you nearly a million dollars!

Try It Yourself

The math can be complex to do by hand, which is why we built our free Compound Interest Calculator. Try plugging in your own numbers to see how your money can grow over time!