The 8th Wonder of the World: How Compound Interest Creates Wealth

When it comes to building long-term wealth, the single most powerful mathematical force in the universe is compound interest. Unlike simple interest, which only pays returns on your original principal, compound interest pays you returns on both your principal and the previously accumulated interest.

The Snowball Effect

Imagine pushing a small snowball down a long, snow-covered hill. As it rolls, it picks up more snow. The larger it gets, the larger surface area it has to pick up even more snow at an accelerating rate. This is exactly how compounding works.

Consider an initial investment of $10,000 placed in an index fund returning 8% annually.

• Year 1: You earn $800. Your new balance is $10,800.
• Year 2: You don't just earn $800 again. You earn 8% on $10,800, which is $864. New balance: $11,664.
• Year 10: Your balance is $21,589. You've more than doubled your money without adding a single cent.
• Year 30: Your balance is $100,626. Over $90,000 of that is pure interest.

Time is Your Greatest Asset

The variable that supercharges the compound interest formula isn't the rate of return or even the principal—it happens to be time. Because time is an exponent in the compounding formula, starting to invest at age 25 versus age 35 can literally result in hundreds of thousands of dollars in difference by retirement age.

To see the snowball effect applied to your own savings goals, use our Interest Calculator to model various timeframes. If you want to calculate your current historical returns, use the Investment Return Calculator to figure out your Compound Annual Growth Rate (CAGR).