What Is Compound Interest?
Written by Andrea Coombes
Edited by Carolyn Kimball
Fact-checked by Dayana Yochim
Compound interest is when the money you earn on your money earns money. This is both an incredibly simple idea and an amazing and magical thing.
Quick take: Say you put $1,000 in a bank account earning a 4% interest rate and it compounds annually. After a year, you’d have a total of $1,040 in your bank account. Can you guess what you’d have in your account after the second year? It would be $1,081.60.
Tell me more! Let's look at your account a little more closely. If you guessed that you'd have exactly $1,080 after two years, that’s not a bad guess. After all, you’ve got $1,000 earning 4% interest, or $40, each year for two years in a row. But there’s some extra money hiding in the couch cushions, thanks to compound interest.
Because the interest you earned in your first year also itself earned interest, you’d actually have $1,081.60. Now, that extra little $1.60 is tiny, no doubt about it. The rewards of compound interest need a little time to rev up. But over time, as ever-larger amounts of your interest earn interest, the benefits are big.
Assuming a 4% interest rate, compounded annually:
- $1,000 in that bank account for 20 years grows into more than $2,190. (If compounding wasn’t happening, you’d have $1,800.)
- $10,000 in that bank account for two years grows into $10,816. (Compounding has given you that extra little $16 boost there, on top of the $400 you’re earning each year on your $10,000.)
- $10,000 in that bank account for 20 years grows into more than $21,900. (You'd have $18,000 without compounding.)
Want to try your own examples? Check out the compound interest calculator at Investor.gov. (It’s confusing, I know. We’re investor.com. But we’re fans of that other site, too.)
One more thing: How often an account compounds makes a big difference in your long-term results. Many accounts compound daily or monthly. When you're earning interest, the more frequent the compounding, the better for you. (In the above examples we used annual compounding for simplicity’s sake.)
Bottom line: Compounding is hugely valuable to you when it comes to saving and investing. But compounding is a lot less fun when you're paying interest on a loan or credit card. If that's your current situation, then check out our story on how to get out of debt.
Did you know?
The Rule of 72 is a compound interest shortcut that tells you how long it’ll take your money to double. Divide 72 by the annual interest rate or rate of return you expect to earn. Say you expect to earn 6% a year on your $10,000? OK, 72 divided by 6 is 12, so it'll take 12 years for your money to double.
Andrea Coombes, senior writer at investor.com, explains the power of compound interest.
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About the Editorial Team
Andrea Coombes has 20+ years of experience helping people reach their financial goals. Her personal finance articles have appeared in the Wall Street Journal, USA Today, MarketWatch, Forbes, and other publications, and she's shared her expertise on CBS, NPR, "Marketplace," and more. She's been a financial coach and certified consumer credit counselor, and is working on becoming a Certified Financial Planner. She knows that owning pets isn't necessarily the best financial decision; her dog and two cats would argue this point.
Carolyn Kimball is Managing Editor for Reink Media Group and the lead editor for content on investor.com. Carolyn has more than 20 years of writing and editing experience at major media outlets including NerdWallet, the Los Angeles Times and the San Jose Mercury News. She specializes in coverage of personal financial products and services, wielding her editing skills to clarify complex (some might say befuddling) topics to help consumers make informed decisions about their money.
Dayana Yochim has been writing (articles, books, podcasts, stirring speeches) about personal finance and investing for more than two decades, focusing on bringing clarity and the occasional comedic aside to what is often a murky, humorless topic. She’s written for NerdWallet, The Motley Fool, HerMoney.com, Woman’s Day, Forbes, Newsweek and others, and been a guest expert on "Today," "Good Morning America," CNN, NPR and wherever they’ll hand her a mic.
