According to Albert Einstein, “compound interest is the greatest mathematical discovery of all time.” In simple terms, compound interest earns interest income on your interest income, thus growing your money faster than ever. Most savvy investors use the power of compound interest to capitalize on the benefits of compounding and get rich even during the hardest of times.

Understanding compound interest

To better understand how compound interest works, let’s assume that you invest $200 at an 8 percent earnings rate. At the end of year one you will have $216, which is $16 earned in interest. If you invest the $216 for another year at 8 percent, at the end of year two you will have $233.3, which is $17.3 earned in interest. Put the $233.3 for another year at 8 percent and at the end of year three you will have $251.97, which is $18.7 earned in interest. In three years you have earned almost $52 on your investment, which, given the current market situation and the global financial crisis, is a crazy number.

There are three factors that influence the rate of compound interest: (1) the interest rate earned on your investment, (2) the investment horizon you can leave your money to compound and (3) the tax rate and the timing that the taxes should be repaid to the government. In fact, the longer the investment horizon, the bigger the return on your investment. In the above example, the interest earned in three years is $52. If the money is reinvested for another seven years the total return on investment in ten years will be almost $200. Regarding taxes, you will have more accumulated capital at the end of ten years if you don’t pay taxes at all or if you pay once and for all at the end of the compounding term rather than each year.

The importance of starting early

To understand how important it is to start letting your money earn compound interest as early as possible let’s assume that you are 22 years old and contribute $3,000 to your IRA at an average 7 percent annual return. If you never withdraw money from your IRA, the $3,000 will grow to $140,000 by the time you retire at your 65. But if you wait another 20 years to start putting money in your IRA, your $3,000 will grow to $60,000 because there will be significantly less time to compound. Each dollar you invest/save in your 20s can earn significantly more compound interest for a period of 45 years until you retire. On the contrary, if you start investing/saving in your 40s, your money will have 25 years less to compound. And maybe in the short-term it doesn’t make a big difference, but on your road to wealth over a course of thirty years the results will be visible.

In short, compound interest is the basis on which the concept of the time value of money is built. This means that money has different value for each person depending upon the time it is earned. $50 earned today make more financial sense than $50 earned after 5 years for two fundamental reasons: (1) you have the money at hand today, and you can re-invest it immediately at the same or a higher interest rate and earn a higher return on investment, pay off your debt, lower your interest expenses and so on, and (2) you cannot estimate the economic conditions after 5 years. So, by postponing the receipt of $50 you actually incur an opportunity cost, meaning what you could have earned had you invested.