Compound Interest

Professor: Today let's talk about compound interest, a concept that comes up constantly in personal finance but that a lot of people misunderstand. Simple interest is calculated only on the original amount of money, but compound interest is calculated on the original amount plus any interest that has already been added. In other words, your money starts earning interest on its own interest. This might sound like a small difference, but over time it becomes significant. Consider a savings account earning interest once a year. In the first year, you only earn interest on your original deposit. But in the second year, you earn interest on your original deposit plus the interest from year one. By year ten or twenty, this compounding effect can dramatically increase the total amount, especially compared to simple interest over the same period. The same principle works against people when it comes to debt. Credit card balances, for example, often compound as well, which is one reason unpaid balances can grow so quickly if they're not paid off. Financial advisors often describe compound interest as one of the most powerful forces in personal finance, precisely because its effects are small at first but accelerate dramatically the longer money is left untouched.