What Is Compound Interest?
Compound interest is one of the most important ideas in personal finance. It means you earn interest not only on your original money, but also on interest that has already been added.
Compound interest in plain English
Suppose you put $1,000 into an account that earns 5% a year. After the first year, you would have $1,050. If the interest is compounded and you leave the money invested, the next year's interest is calculated on $1,050 rather than only the original $1,000.
That extra interest can build on itself over time. The longer the money remains invested and the more frequently interest compounds, the more important the effect can become.
Simple interest vs. compound interest
| Simple interest | Compound interest |
|---|---|
| Interest is based on the original principal. | Interest can be earned on principal plus previously credited interest. |
| Growth is generally more linear. | Growth can accelerate as the balance grows. |
| Useful for some basic calculations. | Commonly used to model savings and investment growth. |
Why compounding frequency matters
Interest may be compounded annually, quarterly, monthly or on another schedule depending on the product. More frequent compounding can produce a higher effective annual yield when the stated interest rate is otherwise the same.
For a basic compound-interest model, the future value can be represented as:
P is the starting amount, r is the annual rate expressed as a decimal, n is the number of compounding periods per year, and t is time in years.
Example
If $5,000 earns 6% annually for 10 years with annual compounding, the ending value is about $8,954. The exact result changes if the rate, time period, contributions or compounding frequency changes.
Compound interest and regular savings
Regular contributions can make the effect more powerful because new money gets its own opportunity to earn returns. A savings or investment plan therefore depends on more than the interest rate: starting balance, contribution amount, time and compounding all matter.
How to use a calculator
- Enter your starting amount.
- Enter the annual interest or return assumption.
- Choose the time period.
- Add recurring contributions if your scenario includes them.
- Compare the projected ending value with the amount you actually contributed.