What Is Compound Interest?
Compound interest is often called the "eighth wonder of the world." Unlike simple interest, which is calculated only on your original deposit, compound interest is calculated on your initial principal plus all the interest that has accumulated over time.
This means your money earns interest on interest, creating a snowball effect that accelerates your wealth growth over the years. The longer your money compounds, the more powerful the effect becomes.
The Compound Interest Formula
The standard compound interest formula is:
A = P(1 + r/n)nt Where:
- A = Final amount (principal + interest)
- P = Principal (initial investment)
- r = Annual interest rate (as a decimal)
- n = Number of times interest compounds per year
- t = Number of years
How Compounding Frequency Affects Your Returns
The more frequently interest compounds, the more you earn. Here is how different frequencies compare for a $10,000 investment at 7% annual interest over 10 years:
- Annually: $19,671.51
- Quarterly: $19,897.89
- Monthly: $19,967.16
- Daily: $20,137.53
While the difference may seem small, it becomes significant with larger amounts and longer time periods.
Tips to Maximize Compound Interest
- Start early. The earlier you begin investing, the more time compound interest has to work.
- Contribute regularly. Even small monthly contributions add up significantly over decades.
- Reinvest dividends. Automatically reinvesting dividends compounds your returns further.
- Minimize fees. High fees eat into your compounding returns over time.
- Be patient. Compounding is most powerful over long periods—think decades, not months.
Compound Interest vs. Simple Interest
With simple interest, you earn interest only on the original principal. For example, $10,000 at 7% simple interest earns $700 per year, every year—always $700.
With compound interest, you earn interest on your principal plus accumulated interest. In year one, you earn $700. In year two, you earn $749 (7% of $10,700). Each year, the interest amount grows.
After 20 years, $10,000 at 7% becomes $24,000 with simple interest but $38,697 with compound interest—a difference of over $14,000.
Frequently Asked Questions
What is a good compound interest rate?
Historically, the U.S. stock market has returned an average of about 10% per year before inflation (about 7% after inflation). High-yield savings accounts typically offer 4-5% APY, while CDs may offer 3-5% depending on the term.
How often should interest be compounded?
More frequent compounding is better for the investor. Most savings accounts compound daily, while many investment accounts compound based on dividend payment schedules (often quarterly). The difference between daily and monthly compounding is usually minimal.
Can compound interest work against you?
Yes. When you borrow money (credit cards, loans), compound interest works against you. Credit card debt, which often compounds daily at rates of 15-25%, can grow rapidly if only minimum payments are made.