The Power of Compound Interest

Simple interest vs. compound interest

Simple interest is calculated only on your original amount, every time. If you put $1,000 into an account paying 5% simple interest, you earn $50 every year, forever — always based on that original $1,000.

Compound interest is different: you earn interest on your original amount and on all the interest you've already earned. That same $1,000 at 5% compounded annually earns $50 in year one, but in year two you earn 5% on $1,050 — not $1,000. The gap between simple and compound grows slowly at first, then dramatically over time.

The "time in the market" effect

Because compounding builds on itself, the single biggest factor in how much you end up with usually isn't how much you invest — it's how long you leave it invested. Someone who invests $200/month starting at 22 and stops at 32 (just 10 years of contributions) will typically end up with more at 65 than someone who invests the same $200/month starting at 32 and never stops, purely because of the extra decade of compounding on those early contributions.

This is why the advice "start now, even with a small amount" matters more than "wait until you have more to invest." Every year you delay is a year of compounding you can't get back.

The Rule of 72

The Rule of 72 is a quick mental shortcut for estimating how long it takes an investment to double at a given annual return: divide 72 by the interest rate. At 8% average annual returns, money roughly doubles every 9 years (72 ÷ 8 = 9). At 6%, it takes about 12 years.

This trick won't give you an exact answer, but it's accurate enough to sanity-check projections in your head, without needing a calculator or spreadsheet.

How fees quietly erode compounding

A 1% annual fee sounds tiny, but because it's subtracted every single year — compounding in reverse — it can eat a shocking amount of your final balance over decades. Two people investing identically for 30 years, one paying 0.05% in fees and the other paying 1%, can end up with a final balance that differs by tens of thousands of dollars, purely from that fee gap.

This is why expense ratios (covered in Unit 3) matter so much more than they seem to at first glance — the damage isn't visible year to year, only decades later.

Key terms

Compound interest

Interest calculated on both the initial principal and the accumulated interest.

Simple interest

Interest calculated only on the original principal, never on interest already earned.

Rule of 72

A quick formula (72 ÷ rate) estimating how long an investment takes to double.

Time horizon

How long you plan to keep money invested before needing it.

Principal

The original amount of money invested.

Annual return

The percentage an investment gains, or loses, in a year.