How to make your money grow | Banking | Financial Literacy | Khan Academy

In this video, we're going to talk about the power of compound interest. To help us understand that, we're going to compare it to simple interest.

Let's say we have an interest rate of 16% per year and we put in initially $1,000. Simple interest would tell us that every year that goes by, we're going to get 16% of that $1,000 added to the amount of money we have. So, 16% of $1,000 is $160. You can see right over here every year that goes by, we are adding $160.

Now, compound interest, at first, it might seem like a small or a subtle change, but it has huge consequences. Over here, we've calculated compound interest for several different interest rates. But since we had 16% on the simple interest, let's compare that to 16% on the compound interest.

So, in the first year, it looks very similar. We start with $1,000; 16% of $1,000 is $160, so we added $160. But we start to see a difference in year two. What do you think is the difference?

Why are we now adding more? If we just added another $160, we would get to $1,320 like we had here, but here it looks like we're getting $26 extra dollars than we had before. Where did that $26 come from? Well, it's because we're not just getting 16% on our original $1,000, like we had in our simple interest. We're getting 16% on the amount of money we had in the previous year, and the previous year had interest from the year before that included in it. So, we're actually getting interest on the interest.

We're getting 16% on the $1,000, and then we're also getting 16% on that $160 that we got the previous year. You add them together, and we're getting more money. Now, you might say, "Hey, let me just write that down." This looks like we got $186 in year two.

Now, this might seem like a small change, but when you really compound its effect—no pun intended—or actually, pun is very much intended, you see that it really builds. And time is a really important factor. Compounding interest really pays off over time.

Look at the difference after 10 years; it looks like we have almost 50% more money with the same interest rate. It's just compounding in this situation versus it's simple in the other one. But after 20 years, we have almost—or actually, we have more than four times the money.

So, compound interest is a very big deal. The good news is most accounts that you have that are giving you interest, as long as you keep the interest that you're earning in the account, they compound. So, whether it's your savings account, a certificate of deposit, or even if you're thinking about returns in the stock market, every year the return you're getting—if you're keeping all your money in the account—it compounds on the previous year.

And what you could see is that time really, really, really matters. Sometimes you might think at the beginning of your career, "Oh, I can only save $50 a month, $100 a month, $200 a month." But if you start early and you get reasonable interest rates, and you allow that to compound over time, it can turn into a lot of money.