Compound interest
Also called: compounding, compound growth
Interest earned on your interest, so growth accelerates instead of staying flat.
Simple interest pays you on what you put in. Compound interest pays you on what you put in and on everything it has already earned — so each year’s growth becomes part of next year’s base.
Over a few years the difference is small. Over decades it dominates. Contributing 200 a month for thirty years at an assumed 7% produces roughly 244,000 from 72,000 of contributions: about seventy percent of the result is growth rather than money you added.
The mechanism is indifferent to direction. It builds wealth on investments and destroys it on debt, which is why a credit card at 22% is so corrosive — the balance you did not clear this month becomes part of the balance charged next month.
Two things drive it: the rate, and the number of years. Of those, years matter more and are the one you cannot buy back later.
Words on this page
- Interest — The price of using someone else's money — paid by borrowers, earned by lenders.
- Option — A contract giving the right to buy or sell something at a set price before a set date.
Related terms
Covered properly in Learn.