By Patricia Uceda, Spring 2015 Graduate Research Assistant
Compound interest is interest that is calculated on the initial amount of money that you invest as well as the interest that you received from earlier interest awards. It differs from simple interest, which is calculated only on the principal amount, and allows you to earn much larger gains on their money over time.
For example, if you invested $1,000 today, and that investment earned a 5% annual gain, your investment would be worth $1,050 after a year. The investment is added to the principal, so next year if you earned another 5% gain, you would be earning 5% on that $1,050, which is $102.50. You are essentially earning interest on the interest you already earned. That is compounding interest.
While those numbers may seem small, interest that is compounding over decades will lead to much bigger numbers, allowing you to save less today but retire with more. For example, if you start saving for retirement at age 25, you only have to save about $4,830 annually to reach $1 million by age 65 (assuming an annual return of 7 percent). If you waited until age 40 to start saving, you would need to save $15,240 per year, assuming the same annual return, to retire at age 65 with $1 million.