Blog
What Is Compound Interest?
Summary
With compounding, you earn returns on your previous returns as well as on your principal. Over time that can make a big difference in both savings and debt.
Compound interest is when you earn interest on your interest, not just on the original amount. Say you put $1,000 in an account that pays 5% per year. After one year you have $1,050. The next year you earn 5% on $1,050, so you have $1,102.50. The year after that you earn 5% on $1,102.50. Over time the growth accelerates because the base keeps getting bigger.
The same idea works against you with debt. If you owe $1,000 on a credit card at 20% and you don’t pay it off, interest is added to the balance. Then you’re charged interest on that new balance. That’s why paying off high-interest debt is so important.
Why it matters for long-term goals
For retirement and other long-term goals, compounding is one of the biggest reasons to start early. The more years your money has to grow, the more the compounding effect shows up. Even small differences in when you start or what rate you earn can lead to big differences in the end.
Definitions
- Principal
- The initial amount of money you invest or borrow, before interest or returns.
- Compound interest
- Interest that is calculated on the principal plus any interest already earned or owed, so you earn (or pay) interest on interest.
FAQ
How does compound interest work for savings?
You earn a return on your money. The next period, you earn a return on the original amount plus the return you just earned. Over many years that can turn modest savings into a much larger sum.
Does compound interest apply to debt?
Yes. With credit cards and some loans, interest is added to the balance, and then you pay interest on that higher balance. That’s why carrying a balance can get expensive quickly.