What is "Compound Interest"?
Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as "interest on interest" and will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount.
[Source: Investopedia]
For simple interest, if you put in $100 with 6% annual interest, by end of Year 1, you would get $106; end of Year 2, you will get $112; end of Year 3, you will get $118.
Every year you get $6 interest.
For compound interest, if you put in $100 with 6% annual interest, by end of Year 1, you would get $106 (same as normal interest); end of Year 2, you will get $112.36; end of Year 3, you will get $119.10.
If you notice, by end of Year 2, you will get extra $0.36 and by end of Year 3 you will get an extra $1.10 compared with normal interest. This is what compounding is, where your interest earned also earn interest for you (e.g. additional 6% on the Year 1's $6 earned interest).
Though the difference is not that great for the first few years, but by end of Year 9, you will notice the difference is getting bigger, to be precise 9.7% more. Populated below is the difference of the interest earned between normal interest (in blue) against compound interest (in orange) based on 6% interest:
As you can see that the orange line (which represents the compounding interest) starts to move exponentially as the time goes. Whereas the blue line (normal interest) just goes up in a line.
This is what happen when you leave your interest gained to be reinvested again making the interest that you earned to earned further interest.
This is the power of compounding interest and as quoted by Albert Einstein:
"Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it."
About the last few words: "he who doesn't ... pays it." What it meant is that it's also applicable for loans or credit that you borrow. E.g. if you just pay the minimum amount of your credit card bill, your loan amount will be like the orange line above where it'll grow and skewed upwards.
Just to add:
For Simple Interest, it takes 17 years to double your money at 6% interest, but Compound Interest takes only 12 years. It saves you 5 years!
By end of Year 21, the interest gained from Compound Interest is 50% more than Simple Interest
Just add another 9 years, by end of Year 30, the interest gained by Compound Interest is 100% more! That is double the total interest earned by Simple Interest
