The Meaning of Compound Interest
Albert Einstein was credited with saying that compound interest was one of the greatest mathematical inventions in history. Earning compound interest on your investment multiplies the earnings that you receive on your savings and investments. Young investors especially stand to benefit from the phenomenon of compound interest.
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Definition
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Compound interest refers to the payment of interest on the principal, or actual funds saved or invested along with payments applied to the interest originally earned on the principal. With compound interest, interest payments are continually added to the principal and the larger principal continues to earn interest. In the formula for compound interest, A (amount of total earnings) is equal to the product of P (principal) multiplied by the sum of the number 1 plus r (annual interest percentage rate) divided by n (number of times each year that the interest is compounded).
Simple Interest Versus Compound Interest
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Compound interest differs from simple interest; simple interest refers to the interest earned on the principal. With simple interest, earned interest remains separate from the principal. Your money does grow with simple interest. The applicable interest rate is regularly applied to the principal -- quarterly, annually or during whatever earning period is designated by the financial institution handling your money. However, because of the nature of compound interest, your principal would earn much more money than it would earn under simple interest.
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Time Factor
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If you are a 22-year-old new college graduate who invests $300 per month in an account that earns 10 percent interest every month until you reach age 28, you will have invested $21,600. If you never invested another penny, applying compound interest would result in a nest egg of more than $1 million by the time you reach age 65. However, if you waited to start investing until age 31, you would need to invest the same $300 each month at 10 percent earnings for the next 34 years (a total investment of $126,000) to obtain a nest egg of $1 million, according to "Kiplinger."
Taxes and Inflation
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Two major factors complicate the calculation of what the actual value of your earnings will be once you retire: inflation and taxation. Inflation means that any calculations you make are only a estimate at best. Taxation means that the Internal Revenue Service will want its slice of most of your earnings, although some investment plans, such as a Roth IRA, allow you to defer or avoid tax obligations -- but only if you quality. Consult with your financial adviser about the most advantageous investment plan for your personal circumstances.
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References
- The Free Legal Dictionary: Compound Interest; 2011
- Business Dictionary: Compound Interest; 2011
- "Kiplinger"; Behold the Miracle of Compounding; Erin Burt; November 2007
- DePaul University: Compound Interest Formula
- University of Toronto Mathematics Network: Simple and Compound Interest; September 1997
- "Kiplinger"; Why You Need a Roth IRA; Erin Burt; April 2009
Resources
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