Compound Interest

Definition

Compound interest is interest calculated on both your original deposit (the principal) and the interest you've already accumulated. In other words, your interest earns interest — and the effect builds on itself over time.

How it works

With simple interest, you only earn returns on your original amount. With compound interest, each period's earnings get added to your balance, and future interest is calculated on the new, larger total.

Example: $1,000 at 10% annual compound interest grows like this:

• Year 1: $1,000 × 10% = $100 interest → balance: $1,100
• Year 2: $1,100 × 10% = $110 interest → balance: $1,210
• Year 3: $1,210 × 10% = $121 interest → balance: $1,331

Each year, the interest payment grows — because the balance it's calculated on grows. Over decades, this effect is enormous.

Compounding frequency

Interest can compound on different schedules: annually, quarterly, monthly, or daily. The more frequently it compounds, the faster your money grows. Most investment accounts compound monthly or daily.

The Annual Percentage Yield (APY) accounts for compounding frequency, which is why it's a more accurate measure of actual return than a simple stated rate.

Compound interest and debt

Compound interest works against you when you're a borrower. Credit card balances, for example, compound monthly — meaning unpaid interest gets added to your balance, and next month's interest is calculated on the higher amount. This is why carrying a credit card balance can spiral quickly.

The key insight

Time is the most important factor in compound growth. The longer your money compounds, the greater the effect. Starting early — even with small amounts — consistently outperforms starting later with larger amounts.