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What Does "Compound Interest" Mean?

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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.

Also Known As: compounding interest, compound return, compounding annual growth rate

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