How Compound Interest Works
Compound interest is the interest earned not only on your original investment (the principal) but also on the interest you’ve already earned. This is why it is often called “interest on interest.”
Here’s an interactive view of the core formula:
genui{“finance_accounting_operations_learning_block_staging”:{“type_id”:”COMPOUND_INTEREST”,”content”:”FV = PV(1+r)^n”}}
Simple Example
Suppose you invest ₹10,000 at an annual interest rate of 10%, compounded once a year.
- Year 1
- Initial amount: ₹10,000
- Interest earned: ₹1,000
- Total: ₹11,000
- Year 2
- Interest is now calculated on ₹11,000
- Interest earned: ₹1,100
- Total: ₹12,100
- Year 3
- Interest is calculated on ₹12,100
- Interest earned: ₹1,210
- Total: ₹13,310
Notice that each year’s interest is larger because you’re earning interest on both your original money and the interest accumulated from previous years.
Compound Interest vs. Simple Interest
| Simple Interest | Compound Interest |
|---|---|
| Interest is calculated only on the original principal. | Interest is calculated on the principal plus accumulated interest. |
| Growth is steady (linear). | Growth accelerates over time (exponential). |
| Lower long-term returns. | Higher long-term returns. |
Why Is Compound Interest So Powerful?
- 💰 Your money grows faster over time.
- ⏳ The longer you stay invested, the greater the effect.
- 📈 Regular investing can significantly increase your wealth over the long term.
Real-Life Uses
- Savings accounts
- Fixed deposits (FDs)
- Mutual funds and long-term investments
- Retirement savings
- Education funds
Key Takeaway
Compound interest rewards both patience and consistency. The earlier you start investing and the longer you leave your money invested, the more powerful the compounding effect becomes. Albert Einstein is often credited with calling compound interest the “eighth wonder of the world,” although there is no reliable historical evidence that he actually said it.