What is Compound Interest?
Explained: Compound interest is the eighth wonder of the world. It's interest paid on interest.
Albert Einstein famously said that compound interest is the eighth wonder of the world.
Basically, compound interest means 'interest on interest'.
For example, let's imagine you have $100 today and you decide to put it in the bank, where it earns 10% interest in one year.
After one year, you still have your original $100. But you also have 10% in interest, which works out to be $10.
So in total, you have $110 after one year.
Let's say that you put all of the $110 back into the bank, who promises to pay you another 10% after a year.
This time, the bank will pay you 10% interest on your $110.
So at the end of the second year, you will have your $110 plus an extra 10% interest. Which works out to be $11.
In total, you have $121.
After two years, you have earned $21 in interest, with $1 of interest paid on the interest you earned in year one. That is interest on interest.
This might sound like a small amount of money but if you invest your money in the bank year...after year...after year...for a very long time, you will eventually have a huge amount of money.
That's because your original $100 is earning $10 interest each year, but your interest is also earning more and more of its own interest year.
Mortgages and credit cards are compound interest in reverse. Meaning, the bank gives you some money now, which you must repay. Then, you pay interest over many years.
That's why Albert Einstein also said, "The person who understands compound interest, earns it - the person who doesn't, pays it.