How does Compound Interest work?

Compound interest is really quite remarkable. Imagine you have $100 and you put it in a bank account that offers you an interest rate of 5% per year. This means that at the end of the year, the bank will give you $5, because 5% of $100 is $5. So now, you have $105 in your bank account.

Now, if it was simple interest, the bank would keep giving you $5 every year, because 5% of your original $100 is always $5. Nice and easy.

But that’s not how compound interest works. Compound interest is like a snowball effect. With compound interest, the bank gives you 5% not only on your initial $100 but also on the $5 interest you earned in the first year.

So, in the second year, you won’t just get another $5. You’ll get $5.25, because 5% of $105 (your initial money plus the interest from the first year) is $5.25. The amount you receive this year is more than you received last year because it is compounding.

This process keeps repeating every year. The bank keeps giving you interest on the new total amount, not just on your original money. This way, your money keeps growing faster and faster, just like how a snowball gets bigger and bigger as it rolls down a hill.

That’s why it’s always a good idea to start saving money early, because the longer your money has to grow, the bigger your snowball gets. That’s the magic of compound interest.

“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” – Albert Einstein

Here is a video I made to explain how it works: