What if your money could work for you—even while you sleep?
That’s exactly what happens with compound interest. It’s one of the simplest ways to grow your savings or investments over time. With compound interest, the money you earn from interest gets added to your original balance. Then, you start earning interest on the new, larger amount.
This same concept also applies when you borrow money. If you carry a balance on a credit card or take out a loan with compound interest, the amount you owe can grow quickly.
In this guide, we’ll cover what compound interest is, how it works, the formulas behind it, and some examples that show how it can help—or hurt—your finances.
What is compound interest?
Compound interest refers to the way interest builds on your savings or debt. As you earn interest, it’s added to the original amount, known as the initial principal, and future interest is applied to the principal plus all interest earned.
The opposite of compound interest is simple interest. With simple interest, the interest is calculated only against the initial principal amount, no matter how much interest you accrue over the course of the account.
How Compound Interest Works
Compound interest grows your money by applying interest to both the principal and any previously earned interest. But how often that interest is applied can make a big difference over time.
Here are the most common compounding schedules:
- Annually – Interest is added once per year. This is typical for many savings accounts and certificates of deposit (CDs).
- Quarterly – Interest is added four times a year. Each new quarter builds on the previous balance.
- Monthly – Interest is added every month. This is common for many online savings accounts.
- Daily – Interest is added every day. This can give your balance a small daily boost and is often used by high-yield savings accounts.
The more frequently interest is compounded, the faster your balance can grow. Even small differences in compounding frequency can add up over the years, so it’s worth comparing when choosing an account.
The Rule of 72
One of the most famous shortcuts to estimate the time it takes for an investment to double, given a fixed annual rate of compound interest, is the Rule of 72.
By dividing 72 by the annual rate of return, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself. For example, if an investor expects a 6% annual rate of return on their investment, then it would take roughly 12 years (72 ÷ 6 = 12) for the investment to double.
It’s essential to note that the Rule of 72 is a simplification and works best for interest rates between 6% and 10%. For rates outside this range, the rule can provide skewed results. Nonetheless, it remains a handy tool for quick approximations.
Formula for Periodic Compounding
You don’t have to be a math expert to calculate compound interest, but it helps to know the basic formula.
The standard formula for compound interest is:
A = P(1 + r/n)^(nt)
Where:
- A = Future value (the total amount after interest)
- P = Principal (your starting amount)
- r = Annual interest rate (as a decimal)
- n = Number of times interest is compounded per year
- t = Time in years
Example:
If you invest $1,000 at an annual interest rate of 5% compounded monthly for 10 years:
- P = $1,000
- r = 0.05
- n = 12
- t = 10
A = 1000(1 + 0.05/12)^(12×10) = $1,647.01
So after 10 years, your balance would grow to $1,647.01.
Tip: Most banks and investment apps do this math for you, but knowing the formula can help you compare different savings and investment options.
How much can compound interest earn over time?
The best thing about compound interest is that you can enjoy significant returns over a longer period of time. You don’t even have to add to the initial amount to see gains. That makes it a great, low-risk addition to an investor’s portfolio.
Say you put $1,000 into a high-yield savings account at the age of 20 for a long-term investment. You enjoy a steady 3% APY for the life of the account, but that rate is compounded annually. In 30 years, that beginning balance will have risen to $2,427.26. That’s without putting another dime into the account.
What happens if your interest follows a daily compounding schedule? There’s not much of a difference. After 30 years, your initial investment will have grown to $2,459.51, which is only $32.25 more than annual compounding.
If you added just $10 a month to the same account, after 30 years your balance would grow to $8,136.31. That’s more than triple the balance without contributions.
How to Calculate Compound Interest
You can use the above formula to determine exactly how much interest you’ll earn with compounding. But there’s a much easier way.
A compound interest calculator can help you estimate the rate of return you can expect over time. Here are three to consider:
With a compound interest calculator, you can toy with various annual interest rates and toggle between a quarterly or annual compounding period to determine exactly the terms you need. You can also note just how much small variances in interest rate can change your overall interest accrued.
Who benefits from compound interest?
Just as a compound interest formula can work for you when you’re saving or investing, it can also work against you when you take out credit cards or loans. Credit card companies and lenders let compound interest work to earn them more interest on the money you borrow.
This is another area where a compound interest calculator can help. You can crunch the numbers and compare what one lender or credit card provider is offering against competitors. If you’ll be borrowing thousands or tens of thousands of dollars, the small difference in interest calculated daily vs. annually can save you money.
Applying the Formula for Compound Interest
Once you’ve used the formula to calculate compound interest, it’s time to figure out how to make that interest work for you. You can throw some money in a savings account and wait for the accumulated interest to build, but lower rates that come with these account types will ensure interest grows slower than if you’d put the money elsewhere.
Here are a few vehicles that will help you start earning a better rate of return by leveraging the power of compound interest:
- High-yield savings accounts: You can often find a better annual interest rate on this type of savings account, but be aware that it will vary based on the market.
- Money market account: If you want your money to be accessible, a money market account can be a way to earn a higher interest amount without locking your funds down for a fixed time period.
- Savings bonds: With a savings bond, you lend money to a company or government entity in exchange for a fixed annual interest rate.
- Certificates of deposits: Although CDs do require you to agree to lock your funds away for six months to five years, they generally offer a higher annual rate than savings accounts and money market accounts.
- Investments: Investment returns can be higher, but they also come with a greater risk. With the right investment advice, though, you can not only enjoy the benefits of compounding interest, but you can reinvest any earnings to boost your dividends.
Compound Interest Investments
For long-term growth, the stock market can be an excellent place to see your principal balance flourish. Look for low-risk dividend stocks that will grow slowly, over time. While these types aren’t known for earning money at the same rates as more volatile stocks, you won’t lose sleep worrying about what the stock market is doing.
Another low-risk, high-yield investment option is a REIT. Short for real estate investment trust, this savings vehicle pays dividends that you then reinvest, and you earn dividends on the reinvested amount. This offers compounding benefits similar to a savings option.
What’s the difference between simple and compound interest?
Compounding does not apply to all interest earned. It varies from lender to lender. Some car loans and short-term personal loans use something called simple interest. You’ll also find this type of interest on your student and mortgage loans.
With simple interest, the interest is based solely on the principal amount. If you borrow $1,000, you’ll only ever pay interest on that $1,000. Some savings accounts use simple interest rather than a compound interest formula. This means any interest you earn from your savings will be eliminated.
How to Determine Interest Amount
The total interest you accumulate will consist of the interest gained today, in addition to the interest accrued from prior periods. As long as you know the principal sum, you can determine exactly how much you’ve earned between the time you moved the money into the account and today.
The formula for determining the lump sum you’ve earned on your investment or savings is as follows:
Current value – initial amount = total interest earned.
If you’ve continued to put money into the account since your initial investment, you’ll need to factor that in as well. Calculating compound interest on your investment requires first deducting any sporadic or monthly contribution in addition to your initial deposit.
Current value – initial amount – additional money contributed = total interest earned.
What is half-yearly compounding?
Although it’s not quite as common as daily, monthly, quarterly, or annual interest, half-yearly compounding is an option. With this type of compound interest, every six months, the interest is calculated and compounded. So, the last half of the year, you’re earning interest at a higher rate than in the first half. This can help your balance grow more quickly than with an annual rate.
You may see this type of compounding more often when you’re paying interest than when you’re earning it. Lenders might call it semi-yearly instead of half-yearly. Either way, the interest added to your balance will grow quicker than if you went with a loan that calculates annually.
How can I tell if interest is compounded?
When shopping for a new account, there’s a straightforward method to identify how your interest accumulates. Look for three letters following the rate; these letters will indicate one of two scenarios:
- APR: Short for annual percentage rate, this is a simple interest rate that only offers interest on the principal balance.
- APY: Stands for annual percentage yield, which means the interest accumulates multiple times a year, whether that’s annually, daily, weekly, monthly, or quarterly.
When to Avoid Compound Interest
Compound interest isn’t always a benefit to you, the consumer. That’s why you’ll see “APY” listed after interest rates offered on investments and savings accounts. Financial institutions will boldly list “APR” as the rate you’re getting when you borrow money.
If you end up with credit cards or loans where interest compounds, you’ll pay more over the course of the repayment. With each month that borrowed amount accrues interest, you’ll owe total compound interest on both the principal and the total accrued interest so far. This additional interest charged can add up over time.
Compound Interest and Retirement Planning
When thinking about long-term retirement planning, annual or monthly compounding can be your ally. It allows you to set your money aside without worrying about losing it with stock market fluctuations. If you start early, you can sometimes earn more money over multiple decades, thanks to the power of compound interest, than with other investments that carry more risk.
Some experts use compounding as a wealth creation tool. In that case, compounding happens when an investor puts all earned dividends back into investments to keep those dollars working. Over time, an investor can substantially increase an original principal using the funds earned on it.
Compound Interest and Taxability
As with simple interest, your compound interest counts as taxable income. At tax time, you’ll receive a form from each of your financial institutions detailing the interest you’ve earned during the tax year. You’re expected to claim those funds on your taxes.
One exception is if you’ve parked your money in a tax-deferred account, like a Traditional IRA. The funds will grow, tax-free, throughout your lifetime, with the interest compounding as you go. But when you take the funds out later, you’ll owe taxes on all that interest. During retirement planning, a compound interest calculator can help you come up with the total earnings so you can begin to estimate how much you’ll owe.
How Changing Interest Rates Affect Compound Growth
Your interest rate plays a big role in how fast your savings or investments grow. Even a one or two percentage point difference can mean thousands of dollars over time, especially with compounding at work.
If your rate increases, you’ll earn interest on a larger balance at the new, higher rate. If the rate drops, your previous earnings stay locked in, and future growth will continue at the new lower rate.
That’s why it’s important to compare interest rates and look for accounts or investments that keep pace with inflation, especially for long-term goals.
Final Thoughts
Compound interest is one of the most powerful tools for growing your money. Whether you’re saving, investing, or both, starting early and contributing regularly can help your balance grow faster over time.
As you compare accounts or investment options, look for competitive rates and compounding schedules that work in your favor. Even small improvements can lead to much larger earnings down the road.
