Understanding Compound Interest: The Eighth Wonder

Albert Einstein once reportedly called compound interest the "eighth wonder of the world." He who understands it, earns it; he who doesn't, pays it. But what exactly is it, and how can you make it work for you?

What is Compound Interest?

Simply put, compound interest is "interest on interest." It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.

Imagine you invest ₹1,000 at a 10% annual interest rate.

• Year 1: You earn ₹100 in interest (10% of ₹1,000). Your total is now ₹1,100.
• Year 2: You earn ₹110 in interest (10% of ₹1,100). Your total is now ₹1,210.
• Year 3: You earn ₹121 in interest (10% of ₹1,210). Your total is now ₹1,331.

As you can see, the amount of interest you earn increases each year because you're earning interest on a larger and larger sum. This is the magic of compounding.

The Formula

The formula for compound interest is: A = P(1 + r/n)^(nt), where:

• A = the future value of the investment/loan, including interest.
• P = the principal investment amount (the initial deposit or loan amount).
• r = the annual interest rate (as a decimal).
• n = the number of times that interest is compounded per year.
• t = the number of years the money is invested or borrowed for.

Why Time is Your Best Friend

The most important factor in the compound interest equation is time. The longer your money is invested, the more time it has to grow. Starting early, even with small amounts, can lead to a much larger nest egg than starting later with larger amounts.

Whether you're saving for retirement, a down payment on a house, or your child's education, understanding and utilizing compound interest is the key to achieving your financial goals. It's the most powerful force for wealth creation available to the average investor.