Compound interest is one of the most important concepts that you will encounter along your personal finance journey. And the quicker you understand it, the faster you will be on your way towards financial freedom!
By definition, compound interest is the income generated by your principal (initial contribution) plus earned interest in a given period. That definition may be difficult to understand, so let’s use an example.
Picture this scenario. You deposit $1,000 into your savings account at a 1% interest rate, yielding you $10 of interest that year. The next year, without adding any extra money to your savings accounts, you earn $10.10 of interest.
Every year, your basis for interest income generation grows — and the larger your basis, the larger the interest payment. Take a minute to think about that.
You started with $1,000. In year one, your basis was $1,010, because you earned a $10 interest payment that year. Then, in year two, your basis was $1,020.10 because you earned a $10 interest payment in your first year and a $10.10 payment in your second year, which results in $20.10 generated over the two-year period.
If you’re still not sure how compound interest works, check out this table.
The table shows an initial contribution of $1,000. As the initial contribution generates interest, it is added to the basis (or future value). Then, the larger basis generates more interest income!
Year 1: $10.00 of Interest Income — Year 2: $10.10 of Interest Income — Year 3: $10.20 of Interest Income — Year 4: $10.30 of Interest Income — Year 5: $10.41 of Interest Income
In the breakdown above, your interest income grows every year, which helps to grow the basis for interest income generation.
As I previously mentioned, compound interest is one of the most important financial concepts to understand because it shows you can continuously make money without adding any additional principal!