Compound interest — “interest on interest” — is what turns a modest, dull savings habit into real wealth, provided you give it enough time to work.
Imagine you invest $1,000 at an annual interest rate of 5%. After one year, you’ll earn $50 in interest, bringing your total balance to $1,050. But here’s the magic of compound interest: in the second year, you don’t just earn interest on the original $1,000. You also earn interest on the $50 you earned in interest the first year! So, in year two, you’d earn $52.50 (5% of $1,050). This keeps happening year after year, with your interest earnings growing along with your principal amount. This kind of growth is called exponential and it is common for many processes.
Compound interest only matters in real terms. Inflation works against it the entire time, eroding the purchasing power of every future dollar your investment produces. Let’s say your investment grows at 5% annually, but inflation is also 3%. While your money grows in nominal terms (meaning the actual dollar amount), it loses some purchasing power in real terms (meaning what you can buy with that money). Here’s an example: You invest $1,000 at 5% interest for 10 years. After 10 years, your investment grows to (future value). But if inflation is 3%, so things will cost more in 10 years. So, the real growth of value will be . Be careful not to subtract compound interest rate and inflation rate — you have to divide it as shown.