WHAT IS COMPOUND INTEREST?
If you borrow and then you don't pay your interest for the year, then the interest is added to the total of the loan. Consequently, you will pay interest on the interest you borrowed for the first year. So compound interest is paying interest on interest.
Borrow $10,000 @ 10% interest to be paid back at the end of 10 years with no payments until then:
Owed Owed
Year first of year Interest end of year
1 $10,000 $1,000 $11,000
2 11,000 1,100 12,100 (You paid interest on the interest)
3 12,100 1,210 13,310 (Notice interest is accelerating)
10 23,580 2,358 25,938
Your interest compounds and your trouble compounds.
Einstein called compounding the 8th Wonder - it can work for you, or against you. When you invest it works for you. When you borrow it works against you! He is also quoting as saying compounding is the most powerful force in the universe.
Notice what happens on the other side, investing:
Total Total
Year first of year Interest end of year
1 $10,000 $1,000 $11,000
2 11,000 1,100 12,100 (You earned interest on the interest)
3 12,100 1,210 13,310 (Notice interest is accelerating)
10 23,580 2,358 25,938 2.6 times more than $10,000
20 67,275 6.7 times more
30 174,494 17.4 times more
Notice that the 30 year total is 6.7 times the 10 year total, even though 30 years is only 3 times 10 years! That's compounding (or accelerating!).
