September 23, 2025 — James Jedlic

What is the True Power of Compounding, and How Can You Use it to Your Advantage?

Compounded interest is one of the most powerful tools for wealth creation — especially if leveraged in your early adult life. Simple interest is true to its name; you have a set principal amount and interest rate, and it grows that same amount over time. Whereas compounding gets its power by adding interest — a percent of the whole — to the principal amount each cycle, whether monthly or yearly. By adding to the principal amount each time your wealth begins to grow exponentially, which can achieve steady, consistent returns that add up to large returns over time.

Let's start at the beginning with the difference between the two. Simple interest is a type of interest where the principal amount and interest rate are fixed. Each period, you receive payment on your starting amount, also known as the principal amount. If you start with a $10,000 principal and an 8% interest rate, you will receive $800 in interest each period, and this interest payout remains constant over time. In 20 years, you will still be getting paid $800 per period. After 20 years, you have $26,000. Great, you just created $16,000 with $10,000 and some patience. Simple interest provides linear growth; compounding interest unlocks the exciting new world of exponential growth. If we run the same scenario, but compound it, you can see the difference. $10,000 compounding annually at 8% starts the same. At the end of your first year, you are tied at $10,800. However, the second month is where you start to pull ahead, ending with $11,664. Pretty wimpy, right? Now let's look at the end of our 20-year time frame: $46,609. By simply choosing an investment that compounds, you gained over $20,000.

Over more than one period, compounding will always be better than simple interest. However, it is important to know how to leverage it in your favor properly. When you have an investment that compounds, time is your best friend. The more time you can go without subtracting from it, the more money it will make you. Let's look at a real-world example of how time beats interest rate. One of my favorite examples comes from Morgan Housel in his book, “The Psychology of Money.” He takes two legendary investors, Warren Buffett of Berkshire Hathaway, and the late Jim Simons of Renaissance Technologies. Both men have amassed massive fortunes, 147.1 billion and 31.4 billion, respectively. Now, guess who had the higher returns. Simons returned 66% annually since 1988. 3 times as much as Buffett’s 22% returns. So how does Buffett have so much more money? The answer is simple: time. Buffett’s first investment was when he was 11 years old. Simons didn’t hit his investment stride until he was 50. The man who returned 3 times as much died 115.7 billion dollars poorer because he simply started too late. The point of that example isn't to scare you into investing all your money right now. It's to show you that time is king. When you pick investments, choose ones that will grow steadily for decades, not flashy ones that stagnate after a few years.

Now it's time for everyone's burning question: how can I use this? The answer is simple. If you are a cautious person, use a high-yield savings account (HYSA). High-yield savings accounts offer low returns but are sponsored by a bank and therefore considered almost risk-free. A HYSA can also have some restrictions on how to access your money, and the main risk of a HYSA is that inflation outpaces your returns, eroding your purchasing power, meaning the same amount of money will buy you less than before. And, while the conventional wisdom is to use a HYSA, they don't take full advantage of compounding. For those willing to take on more risk, the stock market is where you go. Once you start investing in the stock market, you open the door to much larger returns. The most well-known example is the S&P 500. If you invest your entire portfolio in the S&P 500, it will return you, on average, 8% annually. Much higher than a HYSA. However, there are years when it returns less, or even loses value. That's where your risk tolerance comes in. The stock market is inherently risky, and while it's possible to make a lot of money, it's equally possible to lose a lot.

All the same principles that apply to wealth creation also apply to debt, meaning it can be uniquely destructive if misused. The most popular form of compounding debt is credit card debt. Most credit cards compound daily. The compounding rate is decided by the Annual Percentage Rate (APR). That rate is divided by 365 to get the daily rate. For the average APR of 24%, each day you don't pay your debt, it compounds by 0.065%. It starts slow; if you compound that on a $6.5k principal (the average in the US) for a week, you end up owing an additional $29.99. If you miss a month, you owe $6,628.68 in total. By missing a month, you burned $128 that could have been used for rent or gas. When it gets truly destructive is if you miss more than that. If you don't repay your credit card for a year, your original first month's payment will have compounded to $8,262.70. A $1,762.70 increase from your original payment, and that is just for the first month, not including the following months, which also compound. While not paying back a credit card balance for a year is somewhat unrealistic, it serves to show you that when it comes to debt, sooner is always better.

Compounding interest is a force that can either build wealth or create financial struggles, depending on how it is used. By starting early and allowing your investments to grow over time, you give yourself the chance to benefit from their exponential power. At the same time, avoiding compounding debt is just as important to protect your financial future. Understanding this principle and applying it wisely can make the difference between long-term stability and lifelong stress.