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Compound interest is a critical concept in financial planning because it has the potential to significantly impact the growth of your investments. Unlike simple interest, which is calculated based on the principal amount of a loan or investment, compound interest is calculated on both the principal and the accumulated interest from previous periods. This means that the longer your money is invested, the faster it will grow through compound interest.
For example, if you invest $100 at a 10% annual interest rate, you will earn $10 in interest in the first year. If you reinvest that $10 in the second year, your total investment will be $110 and you will earn $11 in interest. This cycle continues, with the amount of interest you earn each year increasing as your investment grows. Over time, the power of compound interest can lead to significant growth in your investment.
In addition to the potential for increased returns, compound interest also has the added benefit of compounding on a regular basis, typically daily or monthly. This allows you to take advantage of the power of compounding even if you are not able to make large lump-sum investments.
Overall, compound interest is an important factor to consider when planning for your financial future. By taking advantage of the power of compounding, you can potentially grow your investments more quickly and achieve your financial goals more easily.