 # The Magic of Compounding | Compound Interest

“Compound interest is the eighth wonder of the world. He who understands it earns it … he who doesn’t … pays it.”

Albert Einstein

In theory, it may seem like a boring math equation. You can skip over to Why it’s magical?

Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, 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.

## Why it’s magical?

Suppose you invest \$1000 at 8% interest in a Fixed Deposit account. Now forget about this investment for the next fifty years. One condition is that all your earned interest will be reinvested automatically.

For the first year, you will get \$82.99 as interest and your principal will rise to \$1008. Now, the interest for the 2nd year will be calculated on 1082.99 dollars. It will be \$89.89 at the end of the second year. Now your principal is 1172.88 dollars.

Doesn’t seems much, right! Just 172.88 dollar increase in 2 years.

Say, this thing keeps happening for the next 48 years like this. Each year, you reinvest your earned interest into the FD and the rate of interest stays the same (i.e. 8%). Then, You will end up with around 50,000 dollars (53878.18 exactly).

It’s a 98% increase from your invested amount. Yes, this is the magic of compounding. You can head over to this website and play around.

## What if you don’t reinvest your interest?

You want to calculate the interest on \$1000 at 8% interest per year after 50 year(s) in case if we don’t reinvest the interest.

The formula we’ll use for this is the simple interest formula, or:

Where:

• P is the principal amount, \$1000.00.
• r is the interest rate, 8% per year, or in decimal form, 8/100=0.08.
• t is the time involved, 50….year(s) time periods.
• So, t is 50….year time periods.

To find the simple interest, we multiply 1000 × 0.08 × 50 to get that:

 The interest is: \$4000.00

Usually, now, the interest is added onto the principal to figure some new amount after 50 year(s),
or 1000.00 + 4000.00 = 5000.00.

So, if we don’t reinvest our interest back to the principal, then the amount at the end of 50 years will just be \$5000 which is significantly lesser than \$53000(gained in case of compound interest.

There are many ways to become a better return on your investment. Read our step by step guide here.