What Is Compound Interest?

The concept of compound interest, or "interest on interest," is that accumulated interest is added back onto your principal sum, with future interest being calculated on both the original principal and the already-accrued interest.

This compounding effect causes investments to grow faster over time, much like a snowball gaining size as it rolls downhill.

Unlike simple interest, which is calculated only on the principal, compound interest is calculated on both the principal and the accumulated interest. This is what makes it so powerful for long-term growth.

When you then start introducing regular, consistent investing over a sustained period of time, the effects of compound interest are amplified, giving you a highly effective growth strategy for accelerating the long-term value of your savings or investments.

How does compounding work?

To illustrate the effect of compounding, let's compare three scenarios using a $1,000 investment over 20 years at a 10% annual rate:

No interest: $1,000 stays$ 1,000
Simple interest: $\$1,000 + (\$100 \times 20) = \$3,000$
Compound interest: $\$1,000 \times (1.10)^{20} = \$6,727.50$

The difference is dramatic. Compound interest earns you an extra $3,727.50 compared to simple interest on the same investment.

A quote from Warren Buffett

"My wealth has come from a combination of living in America, some lucky genes, and compound interest."

— Warren Buffett

The power of time

Time is the most critical factor in compound interest. Consider two investors:

Investor A starts at age 25, invests $200/month for 10 years (total:$ 24,000), then stops.
Investor B starts at age 35, invests $200/month for 30 years (total:$ 72,000).

At age 65 with 7% annual returns, Investor A will have more money than Investor B despite investing only one-third as much. This is the power of starting early.

Compound interest vs simple interest

Feature	Simple Interest	Compound Interest
Calculated on	Principal only	Principal + accumulated interest
Growth	Linear	Exponential
Best for	Short-term loans	Long-term investments
Formula	$A = P(1 + rt)$	$A = P\left(1 + \frac{r}{n}\right)^{nt}$

Where compound interest applies

Compound interest applies to many financial products:

Savings accounts — interest compounds daily or monthly
Certificates of Deposit (CDs) — typically compounded daily or monthly
Bonds — coupon payments can be reinvested
Stocks — reinvested dividends compound over time
Retirement accounts (401k, IRA) — tax-advantaged compounding
Loans and mortgages — compound interest works against you here