Financial Planning
The Power of Compound Interest: The '8th Wonder of the World'
This guide explains the single most powerful concept in finance. Learn how compound interest works and why starting to save early is so critical.
Albert Einstein reportedly called compound interest the "eighth wonder of the world." While the quote's origin is debated, its sentiment is not. Compound interest is the single most powerful force in personal finance. Understanding and harnessing it is the key to building significant wealth over time.
What is Compound Interest?
Interest on Your Interest
Simply put, compound interest is the interest you earn not only on your initial principal but also on the accumulated interest from previous periods. Your money starts working for you, and then the money it earns also starts working for you, creating a snowball effect that can lead to exponential growth.
Why Starting Early is Everything
The most crucial ingredient for compound interest is **time**. Let's look at a simple example:
Saver A: Starts Early
Starts saving $5,000 per year at age 25. After 10 years, at age 35, she stops saving completely.
Total Contribution: $50,000
Saver B: Starts Later
Starts saving $5,000 per year at age 35 and continues for 30 years until age 65.
Total Contribution: $150,000
Assuming a 7% annual return, who has more money at age 65?
Saver A, the early starter, ends up with more money despite contributing only a third of the amount. That's the power of giving your money more time to compound.