Albert Einstein reportedly described compound interest as "the most powerful force in the universe." What is compound interest? How will it help you grow your investments, retire early, or become a millionaire?
Compound interest refers to the interest that is generated by your principal PLUS its interest.
"What?" Don't worry if that sounded like gibberish. Just stick with me for a second.
Imagine that you put $100 into a retirement investment account. It earns interest at a rate of 10 percent per year. At the end of Year 1, you have $110.
You start Year 2 with $110 in your investment account -- $100 from the principal, and $10 from the interest. You keep the full $110, BOTH the principal and the interest, invested throughout Year 2. By the end of Year 2, your investment has grown by another $11, for a total of $121.
Notice that in Year 1, you earned $10 in interest, because the only money that you had was the principal. But in Year 2, you earned $11 in interest, because you had the principal PLUS the first year's interest. In other words, that extra $1 represents interest that compounded on top of your interest.
You start Year 3 with $121 in your investment account. You earn 10 percent, or $12.10. At the end of the year, you have $133.10.
Notice how your 10 percent payout has grown -- from $10 the first year, to $11 the second year, to $12.10 the third year. This is because interest is compounding on top of previous interest.
The fourth year, your 10 percent payment will be $13.31 (which is 10 percent of $133.10), which means you'll end the year with $146.41.
Notice that at this point, you've earned $46 on your original investment of $100. Not bad!
What if you hadn't reinvested your returns? In Year 1, you get a 10 percent return. You keep the principal, the original $100, invested, but you spend the extra $10. At the start of Year Two, you only have $100 invested.
You do this every year -- keeping the original $100 invested, but removing the extra $10. By the end of Year 4, you've made only $40, not $46.41, because you didn't let the interest compound.
"Big deal," you might be thinking. "$6 bucks is not a lot of money."
True. But imagine doing this with $10,000. Using the same formula, you'll earn $4,600 on your original investment by the end of the fourth year, and that $6 has now turned into $600.
Better yet, imagine doing this with $100,000. You'd earn $46,000!
Of course, most investments don't give consistent 10 percent returns -- I just picked that number for the sake of giving an easy example. Investing legend Warren Buffet predicts that the stock market will give 7 percent returns through the next decade or two. Read this article to learn how the rate of return impacts how much time it takes to double your money.