Compound Interest | A Must Know Planning Tool

The Principles of Simple and Compounding Interest when Investing

If you ever think that the concept of compounding interest is not a big deal, think of the declaration by one of the greatest intellects of our time, Albert Einstein, that compound interest is "the most powerful force in the universe" or "the greatest invention in human history."

If you have not heard of the miracle and power of compounding interest, please continue reading this article!

Investors have used it to their advantage to make their investments increase much quicker than would be the case with simple interest. The great thing about compounding is that it doesn't require additional work on your part: you just sit back, relax and watch your money grow. There just aren’t many investment strategies that have that claim to fame!

Compound interest is best used when it is working in your favor. Johnny Carson once quipped during a Tonight Show monologue that "Scientists have developed a powerful new weapon that destroys people but leaves buildings standing; it's called the 17% interest rate!

There are two basic types of interest crediting: Simple and Compound.

Simple interest is the amount of interest earned on the original amount of money invested. Simple interest is paid out as it is earned and does not become part of an account's interest-bearing balance. The invested amount is called principal. Let's say you invest $100 (the principal) at a yearly interest rate of 5 percent. Multiplying the principal by the interest rate gives you an interest payment of $5. This is your simple interest. The next year and each year thereafter, you will be paid $5 of interest on the principal of $100.

Compound interest is interest paid on interest. At 5 percent interest compounded annually, you will have $105 after the first year. If you keep this investment for another year, you will be paid interest on your original $100 and on the $5 you made in interest the first year. The longer you invest your money, the higher your interest payments will grow, not only on your original amount but on the additional interest you earn each year. This is what makes compounding interest so powerful. It is like the proverbial snowball rolling down hill. The long that it is in motion, it continues to gain more and more momentum.

The longer an investment is allowed to compound interest, the faster your balance will grow and the higher your returns will be. In the case of compounding interest, time really is money. Let's say you invest $1,000 for five years, with an annual interest rate of 5 percent. The difference in your investment earnings from simple and compounded interest will look like this:

Compound Interest Example