Compound interest, defined

It’s how your savings can grow exponentially, and it’s how the rich stay rich.

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🌰 In a nutshell: When your money makes money. Or to put it another way, interest on interest. Compound interest is how your savings can grow exponentially, and it’s how the rich stay rich.

OK, let’s put on our math helmets. Ready? Don’t tighten the chin strap too much. Alright: Say you put $100 in an account with a totally gettable 5% annual interest rate, giving you $105 in a year’s time. In two years, you don’t just have $110 — you have $110.25.

That’s because your original $100 — the principal — earned you another $5, and the first year’s $5 — the interest— earned you a quarter. The combo of these two is why it’s called compound interest.

That extra quarter isn’t much, but hold on tight. In 10 years you’ll have $162.89; in 25 years you’ll have $338.64; and in 50 years you’ll have $1,146.74. All starting with $100, a 5% interest rate, your math helmet, and a whole lot of patience. 

👶 Tell a toddler: You know how a snowball gets bigger if you roll it down a hill? The snow that it gathers on the first roll gathers more snow, which then gathers more snow, and soon you’ve got a speeding snowball that’s as big as a house! Watch out! And that’s compound interest.

💬 In a sentence: “Contrary to popular belief, Albert Einstein didn’t say that compound interest is the most powerful force in the universe. Turns out he was more interested in quantum physics than personal finance. Still, it’s pretty powerful.”

👊 Why compound interest matters

It’s how the rich stay rich. There are two ways to make money: Through your work or through your money. Guess which one is taxed at a better rate? This is why you never see a billionaire sweat.

🌎 IRL: Grace Groner bought $180 worth of shares in Abbott Pharmaceuticals in 1935. She worked as a secretary at the company, lived a simple life, and always reinvested the dividends. When she died in 2010, her estate was worth more than $7 million. She gave it all to her alma mater, Lake Forest University, and it’s estimated to have helped more than 1,000 students.

🔀 See also: The Rule of 72, Origami.