What is compound interest?

The concept of compound interest is essential to understanding how savings and investments grow over time. Compound interest is defined as interest that is calculated not just on the initial principal amount, but also on the accumulated interest from previous periods. This means that as time passes, you earn interest on your interest, leading to exponential growth of your investment or savings.

For instance, if you invest $1,000 at an annual interest rate of 5%, the interest earned in the first year would be $50. In the second year, you earn interest on the new total of $1,050 rather than just the original $1,000, resulting in $52.50 in interest for the second year. This process continues, allowing your investment to grow faster than it would with simple interest, which only considers the original principal.

Understanding compound interest is critical for making informed financial decisions, as it highlights the benefits of long-term investments and savings plans. It shows how a small initial investment can grow significantly over time due to the nature of compounding, particularly when you leave your money invested and allow it to accumulate interest over multiple periods.