Glossary · Definition
Compound interest
Compound interest is interest earned on both your original money AND the interest it's already earned. Over long periods, this 'interest on interest' effect is what turns modest monthly contributions into retirement-level balances.
Definition
Compound interest is interest earned on both your original money AND the interest it's already earned. Over long periods, this 'interest on interest' effect is what turns modest monthly contributions into retirement-level balances.
What it means
Simple interest is linear — if you deposit $10,000 at 5% simple interest, you earn $500 per year, every year, forever. Compound interest is exponential — you earn $500 in year one, but now you have $10,500, so in year two you earn $525 (5% of the new balance), then $551 in year three, and so on. Over 40 years at 5% compounding annually, $10,000 grows to about $70,400. At 8% (typical stock-market average return), it grows to about $217,000. The gap between 5% and 8% doesn't look like much in year one ($300 difference) but over 40 years it's the difference between $70k and $217k — compounding rewards both time and rate.
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Formula
A = P(1 + r/n)^(nt) where A = end balance, P = principal, r = annual rate, n = compounds/year, t = years
Why it matters
Compound interest is the single most important concept in personal finance. It's why starting retirement contributions at 25 instead of 35 matters far more than the raw $10 × 12 × 10 = $1,200/mo math suggests. A 25-year-old investing $500/month at 8% has $1.75M at 65. The same person starting at 35 has only $746K — less than half. The extra decade of compounding, not the extra dollars, does most of the work.
Example
A $200/month contribution from age 22 to 65, at 8% compounding monthly, grows to approximately $930,000. The same contribution starting at age 32 grows to only $402,000. That 10-year head start is worth $528,000 of retirement money.
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Frequently asked questions
How often should my account compound?
More frequently is better, but the difference between daily and monthly compounding is tiny (<0.05% APY). Focus on the underlying rate and consistency of contributions, not compounding frequency.
Can compound interest work against me?
Yes — credit card debt is compound interest in reverse. A $5,000 balance at 24% APR that you make minimum payments on can take 20+ years to pay off, costing 2-3× the original balance.
What's the 'rule of 72'?
A shortcut: divide 72 by the interest rate to estimate how many years it takes money to double. At 8%, money doubles in about 9 years; at 6%, about 12 years.
Related terms
- DefinitionAPYAPY (Annual Percentage Yield) is the total yearly return on a savings account, CD, or investment — expressed as a percentage and including the effect of compounding. When comparing savings products, APY is the fair number.
- DefinitionAPRAPR (Annual Percentage Rate) is the total yearly cost of borrowing money, expressed as a percentage — including the interest rate plus most fees. It's the number you should compare between loans, not the 'interest rate'.
- DefinitionAmortizationAmortization is the process of paying off a loan with equal periodic payments that are split between interest and principal. In the early months, most of your payment goes to interest; as the balance shrinks, more goes to principal.