Albert Einstein once said that compound interest is the eighth wonder of the world. It can help you build wealth, but if not used wisely, it may also lead to increasing debt. So, what exactly is compound interest and how does it work? Let’s explore this topic in an accessible way, based on reliable sources.
What Is Compound Interest?
Compound interest is a method of calculating interest where the earnings from a given period are added to the initial investment. This means that in subsequent periods, you earn interest not only on the original amount but also on the interest accumulated in previous periods. As a result, your capital grows faster—this is the effect of “interest on interest.”
How Does It Work?
Imagine you invest a sum of money. At the end of the first period, you receive interest, which is then added back to your account. In the next period, the interest is calculated on the larger sum—the original investment plus the earned interest. This process repeats itself, and over time, your savings steadily increase.
Example of How It Works
Suppose you invest 5,000 PLN at an annual interest rate of 5% with interest compounded once a year over a period of three years:
- First Year:
5,000 PLN × 1.05 = 5,250 PLN - Second Year:
5,250 PLN × 1.05 ≈ 5,512.50 PLN - Third Year:
5,512.50 PLN × 1.05 ≈ 5,788.12 PLN
As you can see, after three years, your savings grow thanks to the automatic reinvestment of interest—without any additional deposits.
Simple Interest vs. Compound Interest
-
Simple Interest:
Interest is calculated only on the initial investment. As a result, you receive a fixed amount of interest, and the principal remains unchanged. -
Compound Interest:
Interest is added to the principal, which means that in subsequent periods, you earn interest on both the original investment and the accumulated earnings. This is what makes the method so effective for long-term saving.
Why Is It Important to Start Early?
Time is a key factor when it comes to compound interest. The earlier you start saving and reinvesting your earnings, the longer your money has to “work” for you. Even small, regular contributions can grow significantly over time. Younger investors have an extra advantage—they have more time to learn and refine their financial strategies.
Real-World Impact on Investments
A great example of the power of compound interest is Warren Buffett, whose fortune is measured in tens of billions of dollars. Part of his success comes from the ability to reinvest earnings, which continually multiplies his capital. This demonstrates how a long-term investment strategy based on compound interest can be a powerful tool in building wealth.
Practical Tips
-
Reinvest Your Interest:
Keep the interest in your account so that it can continue to generate further earnings. -
Choose Investment Products with Compounding:
Look for savings accounts, deposit products, or stocks that offer the possibility of reinvesting earnings. -
Think Long-Term:
The benefits of compound interest become apparent over several years, so patience is key.
Summary
Compound interest is a powerful financial tool that allows your savings to grow through the “interest on interest” effect. By starting early and consistently reinvesting your earnings, you can significantly increase your capital over time. This strategy works well for both saving and investing, regardless of your age.
