Understanding Compound Interest: How It Works and Why It Matters

Compound interest is the addition of interest to the principal amount, which then earns interest on both the principal and the previously accumulated interest. This compounding effect causes the investment to grow at an accelerating rate over time.
For example, if you invest $100 with a 5% annual interest rate, after one year you will have $105 (the original $100 plus $5 in interest). In the second year, you will earn 5% interest not only on the original $100, but also on the $5 in interest earned in the first year, so your total balance will be $110.25 ($100 + $5 + $10.25). This is how compound interest works, and it can lead to significant growth over time.
Compound interest can work against you if you are borrowing money, as the interest charges will compound and increase the amount you owe. For example, if you borrow $100 at a 5% annual interest rate, after one year you will owe $105 (the original $100 plus $5 in interest). In the second year, you will owe $110.25 ($105 + $5 + $10.25), and so on.
It is important to understand how compound interest works when making investment decisions or taking out loans, as it can have a significant impact on your financial situation over time.