What Is Compound Interest?
Compound interest is interest earned on both your original principal and previously accumulated interest - 'interest on interest.' Unlike simple interest (calculated only on principal), compound interest grows exponentially over time. This makes it powerful for long-term savings: $1,000 at 7% compounds to $1,967 in 10 years vs $1,700 with simple interest.
Key Takeaways
- With simple interest, you earn the same amount each period.
- Compound interest works against you with debt - credit card balances grow quickly at 20%+ rates.
- Inflation reduces the real return - 7% nominal return with 3% inflation is about 4% real return.
Explanation
With simple interest, you earn the same amount each period. $1,000 at 10% simple interest earns $100 per year, every year. With compound interest, year one earns $100, but year two earns 10% of $1,100 = $110. Each year the interest amount grows because the base amount grows.
The frequency of compounding matters. Interest can compound annually, monthly, daily, or continuously. Monthly compounding earns slightly more than annual because interest starts earning interest sooner. The difference increases with higher interest rates and longer time periods.
The Rule of 72 provides a quick estimate: divide 72 by the interest rate to find how many years it takes to double your money. At 6% interest, money doubles in about 12 years. At 8%, about 9 years. Starting early dramatically increases wealth because of more time for compounding to work.
Things to Know
- Compound interest works against you with debt - credit card balances grow quickly at 20%+ rates.
- Inflation reduces the real return - 7% nominal return with 3% inflation is about 4% real return.
- Tax treatment affects actual returns - tax-advantaged accounts preserve more of the compounding benefit.