compound interest

Compound Interest

Compound interest is interest calculated on both the original amount of money (called the principal) and on any interest that has already been earned or charged. In other words, your interest earns interest of its own over time. This is different from simple interest, which is calculated only on the original principal.

Compound interest typically applies to savings accounts, certificates of deposit, loans, and credit cards. The frequency at which interest compounds varies by product and institution. Common compounding periods include daily, monthly, or annually. Generally speaking, the more frequently interest compounds, the faster a balance grows, whether that works in your favor as a saver or against you as a borrower.

Why It Matters

For savers and investors, compound interest is a powerful tool for building wealth over time. Even modest contributions to a savings account can grow significantly over many years because each compounding period adds to the base on which future interest is calculated. Starting to save early typically produces much larger long-term results than saving the same total amount but starting later.

For borrowers, compound interest can work in the opposite direction. On credit cards and certain loans, unpaid interest is generally added to the balance, and future interest is then charged on that larger amount. In most cases, carrying a balance on a high-interest credit card and making only minimum payments can cause the total amount owed to grow quickly over time.

Example

Suppose you deposit $1,000 into a savings account with a 5% annual interest rate, compounded annually. After the first year, you earn $50 in interest, bringing your balance to $1,050. In the second year, the 5% rate applies to the full $1,050, not just the original $1,000, so you earn $52.50 in interest. Your balance is now $1,102.50. Over many years, this effect compounds and the growth accelerates, even without adding any new deposits.

Related Terms

• Simple interest: Interest calculated only on the original principal, not on accumulated interest.
• Annual Percentage Yield (APY): The real rate of return on a deposit account, reflecting the effect of compounding over one year.
• Annual Percentage Rate (APR): The yearly cost of borrowing, typically expressed without accounting for compounding within the year.
• Principal: The original sum of money deposited or borrowed, before interest is applied.
• Amortization: The process of paying off a loan through regular payments that cover both principal and interest over time.