Compound Interest
Definition
Interest calculated on both the initial principal and the accumulated interest from previous periods, causing wealth to grow exponentially rather than linearly over time.
Compound interest is the mechanism that turns small, consistent investments into substantial wealth over time. When you earn interest on your interest (not just your original deposit), growth becomes exponential. Einstein allegedly called it the eighth wonder of the world, and while the attribution is disputed, the math is undeniable.
Consider a $10,000 investment earning 8% annually. With simple interest, you'd earn $800/year, reaching $34,000 after 30 years. With compound interest, the same investment grows to $100,627 — nearly three times as much — because each year's interest earns interest in subsequent years.
The Rule of 72 provides a quick estimate of compounding: divide 72 by the annual return rate to approximate how many years it takes to double your money. At 8% returns, money doubles roughly every 9 years. At 10%, every 7.2 years. This simple rule illustrates why starting to invest early is so powerful.
Compounding frequency matters. Interest can compound daily, monthly, quarterly, or annually. More frequent compounding produces slightly higher returns. A 5% APR compounded daily yields an APY of 5.13%. Banks often advertise APY (which includes compounding) rather than APR for savings products, and APR for loans.
The dark side of compound interest is that it works against you with debt. Credit card debt at 20% APR compounds against you, which is why minimum payments barely dent the principal. Understanding compounding motivates both investing early and paying off high-interest debt quickly.
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Related Terms
Frequently Asked Questions
How is compound interest different from simple interest?
Simple interest is calculated only on the original principal. Compound interest is calculated on the principal plus all previously accumulated interest. Over short periods the difference is small, but over decades it becomes dramatic — compounding turns linear growth into exponential growth.
Why does starting to invest early matter so much?
Because of compounding, the first dollars you invest have the most time to grow. Someone investing $5,000/year from age 25-35 (10 years, $50,000 total) will likely have more at age 65 than someone investing $5,000/year from age 35-65 (30 years, $150,000 total) at the same return rate.