How TF Does Compound Interest Work? (Because Honestly, It’s Overcomplicated)

Investing
Written By SOTM Team

Okay, let’s get real. You’ve probably heard the term compound interest thrown around a million times. Some financial expert said it’s the “eighth wonder of the world,” and now we’re all supposed to know what that means. But if you’re still sitting there thinking, Cool, but how does it actually work?, you’re not alone.

Let’s break it down. No finance degree required.

Compound Interest in Plain English

Imagine you plant a little money tree (cute, right?). Every year, it grows a few extra branches (aka interest). But here’s the magic: the next year, not only does your tree grow more branches, but those branches start growing their own little branches.

In other words, with compound interest, you earn interest on your initial money and on the interest you’ve already earned. It’s like a financial snowball, rolling downhill and getting bigger and bigger.

The Formula (But Make It Friendly)

Okay, if you’re a numbers girlie, here’s the official formula:

A=P(1+rn)ntA = P \left(1 + \frac{r}{n}\right)^{nt}

Don’t freak out. Let’s break that down into English:

  • A = The total amount you’ll have (including interest)

  • P = How much you started with (your principal)

  • r = The interest rate (expressed as a decimal)

  • n = How many times the interest is applied per year

  • t = How many years you leave it alone to grow

But honestly? You don’t need to memorise that. Just know that the longer you leave your money invested, the harder compound interest works for you.

A Real-Life Example

Let’s say you invest $1,000 at an interest rate of 5% per year, compounded annually. You don’t touch it for 10 years.

  • After Year 1: $1,000 becomes $1,050.

  • After Year 2: You earn interest on $1,050, so now you’re at $1,102.50.

  • After 10 years? You’re looking at $1,628.89 without lifting a finger.

Now imagine you keep adding money regularly? That’s when the magic really happens.

Why It’s Basically Free Money

  • Time is your bestie: The earlier you start, the more time your money has to grow. Even small amounts can snowball into something big.

  • Reinvest that interest: Don’t cash out your earnings - keep them in and let them grow.

  • Set it and forget it: Compound interest works best when you leave your investments alone. The less you tinker, the better.

Final Thoughts

Compound interest might sound like a finance buzzword, but it’s really just a way for your money to make you more money. The trick? Get started. Even if it’s just a little.

Because future you? She’s on the money.

Happy investing!

***Please remember our blogs aren’t intended as financial advice - they’re intended only as a starting point to give you a little extra info! For more in-depth advice catered to your personal financial position, please see a certified financial advisor.



SOTM Team
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