  # The Power of Compound Interest

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A common goal for many people seeking financial independence is to create passive income, income that grows with minimal work involved.  Compound interest is an essential factor in passively growing your money and can be a powerful tool for creating wealth.

## What is compound interest?

Let’s start with simple interest first.  Simple interest occurs when you earn interest on your principal (starting) amount of money only.

Where

• A is the total amount you will have at the end of your time period
• r is the annual interest rate
• t is the total number of years
• P is the principal amount you started with

In words:

Final amount = Principal + interest you accrued on starting principal over a set time

Example

Jeff starts out with a principal balance of \$10,000.  He is going to earn 4% interest on this amount for 15 years.  This means that every year Jeff is going to earn 4% of \$10,000.  The first year he would earn \$400, the second year Jeff would earn another \$400, and so on.

Jeff’s simple interest formula would look like:

So, at the end of 15 years Jeff has accrued \$6,000 in interest plus his initial \$10,000 investment for a total of \$16,000 at the end of 15 years.

Now let’s compare this with compound interest.  Compound interest occurs when the interest you earn for a given period is then added to your original principal investment and you earn interest on your new, larger principal.  Basically, the money you earned through interest is now making its own money… passive wealth generation.

Where

• A is the total amount you will have at the end of your time period
• r is the annual interest rate
• n is the number of times the interest compounds yearly
• t is the total number of years
• P is the principal amount you started with

In words:

Final amount = principal plus interest earned compounded at a set frequency of a certain number of years.

### Example

Megan starts out with a principal balance of \$10,000.  She is going to earn 4% interest on this amount compounded monthly for 15 years.  This means that every month Megan earns interest on her original investment and the next month earns interest on her new, larger sum.  The first month Megan would earn \$33 off of her original \$10,000 investment.  She would then get to add that \$33 to her principal giving her a total of \$10,033.  The next month she would earn interest on the new principal of \$10,033 and her principal would continue to grow.

Megan’s compound interest formula would look like:

At the end of 15 years Megan has accrued \$18,203 in interest plus her initial \$10,000 investment for a total of \$18,203 at the end of 15 years.

This means with compound interest Megan has earned an additional \$2,203 by doing absolutely nothing more than Jeff accept picking a better investment than him. Better yet, over 30 years Megan will have made over \$13,000 more than Jeff.

## The bad side of compound interest.

Just as compound interest can help you grow your money more rapidly, it can also cause your debt to compound more rapidly as well.  Most credit card debt is compounded daily, which means that at the end of every day any debt amount you haven’t paid off grows.  This is why it is imperative to tackle your debt as quickly as possible and do not just pay the minimum required balance.