Compound interest is a term that describes the accumulation of interest on previously earned interest and the underlying monetary principal. It differs from simple interest, which only pertains to the principal. Learn how to calculate your compound interest and how impactful it can be over time.
- Written By Thomas J. Brock, CFA®, CPA
Thomas J. Brock, CFA®, CPA
Thomas Brock, CFA®, CPA, is a financial professional with over 20 years of experience in investments, corporate finance and accounting. He currently oversees the investment operation for a $4 billion super-regional insurance carrier.Read More
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Lamia Chowdhury is a financial editor at Annuity.org. Lamia carries an extensive skillset in the content marketing field, and her work as a copywriter spans industries as diverse as finance, health care, travel and restaurants.Read More
- Financially Reviewed ByTimothy Li, MBA
Timothy Li, MBA
Business Finance Manager
Timothy Li, MBA, has dedicated his career to increasing profitability for his clients, including Fortune 500 companies. Timothy currently serves as a business finance manager where he researches ways to increase profitability within the supply chain, logistics and sales departments.Read More
- Updated: March 23, 2023
- 4 min read time
- This page features 2 Cited Research Articles
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What Is Compound Interest and How Does It Work?
Compound interest is the accumulation of interest associated with a principal balance and previously accrued interest. The latter part of the accumulation is what leads many people to describe compound interest as “interest on interest.”
- The nominal interest rate (stated rate) is increased.
- The compounding frequency is increased.
- The time until maturity is extended.
Incidentally, compounding frequency refers to the number of times per year that interest is regularly computed and accumulated.
Most banks offer financial instruments that compound daily, monthly, quarterly, semiannually and annually. If you are investing, then compound interest works in your favor by building wealth — but if you have a loan that’s compounding interest, then you are accruing more debt. Compound interest can affect your personal finances depending on how it is used.
Compound Interest vs. Simple Interest
The best way to illustrate compound interest is to contrast it with simple interest. Compound interest grows exponentially, while simple interest grows linearly. In other words, with simple interest, the interest is computed based solely on the principal balance. There is no compounding of previously earned interest. Let’s clarify things with a simple example.
- Account ABC offers 5% annual interest with no compounding (simple interest).
- Account XYZ offers 5% annual interest compounded annually.
- By the end of the first year, your $1,000 balance will grow to $1,050 ($1,000 × 1.05 = $1,050), yielding $50 of annual interest income.
- By the end of the second year, your balance will grow to $1,102.50 ($1,050 × 1.05 = $1,102.50), yielding $52.50 of annual interest income.
- Then, by the end of the third year, your balance will grow to $1,157.63 ($1,102.50 × 1.05 = $1,157.63), yielding $55.13 of annual interest income.
As illustrated above, the annual interest income for Account XYZ grows continually due to the compounding of previously accrued interest. Essentially, this arrangement gives you an increasingly large base of money to compute future interest. It’s often described as a snowball effect, where a small investment steadily grows bigger and bigger over time, like a snowball rolling down a hill.
How Do You Calculate Compound Interest?
Regardless of the financial instrument, compound interest can be computed easily with the formula below. It computes the interest accumulated over a specified number of years, given the beginning principal, nominal interest rate and compounding schedule.
I = Compound interest
P = Beginning principal amount
r = Nominal interest rate
n = Number of times interest is compounded per year
t = Time in years
For example, assume you invest $10,000 (P) in a debt instrument offering a 4% nominal rate (r). The time until maturity is 15 years (t), and interest is compounded annually (n). As evidenced below, you will earn $8,009.44 (I) by the time the instrument matures.
With simple interest, the earnings would only amount to $6,000 ($10,000 × 0.04 × 15 = $6,000). The compounding effect has created over $2,000 of additional value. Incidentally, if the interest were compounded monthly rather than annually, the interest earnings would be even higher, as shown below.
What Are the Best Compound Interest Investments?
All types of financial instruments offer the prospect of compound interest, but only savings accounts, certificates of deposit, money market accounts and certain fixed-income investments offer guaranteed compounding.
When putting money into these instruments, you should strive to do so as soon as possible – because the longer your time horizon, the greater your money-making potential. Moreover, when selecting an instrument, you should focus on those that offer the highest nominal interest rates and most frequent compounding schedules. This will help you maximize your cumulative earnings.
Can Compound Interest Make You Rich?
When speaking in terms of saving and investing, the power of compound interest is highly accretive to wealth. It can help you make big money in the long term, especially if you start investing early. In fact, a smaller investment early on can help you build more wealth than a bigger investment later.
However, when it comes to borrowing, compound interest has an erosive effect. It causes you to rack up interest charges quicker and can lead to higher levels of debt. Keep this in mind the next time you decide to open a new credit card or other types of revolving line of credit.
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2 Cited Research Articles
Annuity.org writers adhere to strict sourcing guidelines and use only credible sources of information, including authoritative financial publications, academic organizations, peer-reviewed journals, highly regarded nonprofit organizations, government reports, court records and interviews with qualified experts. You can read more about our commitment to accuracy, fairness and transparency in our editorial guidelines.
- Consumer Financial Protection Bureau. (2016, August 1). I Want To Teach My 11-Year-Old About Compound Interest. Is There an Easy Way To Illustrate It? Retrieved from https://www.consumerfinance.gov/ask-cfpb/i-want-to-teach-my-11-year-old-about-compound-interest-is-there-an-easy-way-to-illustrate-it-en-1683/
- Corporate Finance Institute. (2022, May 7). Time Value of Money. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/valuation/time-value-of-money/
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