Albert Einstein famously called compound interest the "eighth wonder of the world." Those who understand it, earn it; those who don't, pay it. But what does it actually look like in practice?
The Magic of "Interest on Interest"
Unlike simple interest, where you only earn money on your principal investment, compound interest is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.
The Rule of 72
A quick way to estimate the power of compounding is the Rule of 72. Simply divide 72 by your annual rate of return, and you'll get the number of years it takes for your initial investment to double.
- At 6%: 72 / 6 = 12 years to double.
- At 8%: 72 / 8 = 9 years to double.
- At 10%: 72 / 10 = 7.2 years to double.
Time is Your Best Friend
The most important variable in the compound interest equation is not the amount of money you start with—it's time. Starting five years earlier can result in a final balance that is hundreds of thousands of dollars higher.
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