What is compound interest?
Interest brings more interest with it.
The interest you earn earns interest too. A small difference at first opens wide over the years — and the same mechanism works on money you borrow.
In 30 seconds
- Compound interest is interest earned both on the money you deposit and on the interest earned along the way.
- Deposit $100 at 5% a year and after 25 years you have almost $340. With simple interest, earned only on the original money, it would be $225.
- The same mechanism works on borrowing. Credit card interest is added to the balance every day.
Interest earns interest.
In the second year, the first year’s interest earns interest too.
Value of $100 deposited at 5% a year for two years (compound)
$105 after one year. In the second year, the $5 of interest earns interest too.
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A small difference
The US Securities and Exchange Commission’s investor site explains that $100 earning 5% a year becomes $105 after one year and $110.25 after two.[1]
In the second year, the original $100 earns $5 and the first year’s $5 of interest earns $0.25. That $0.25 is where compounding begins.
Over 25 years, the gap opens.
A small difference at the start opens wide over the years.
Value of $100 deposited at 5% a year for 25 years (compound)
With simple interest, earned only on the original money: $225.
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The power of time
According to the same page, it passes $162 in 10 years and reaches almost $340 in 25.[1]
With simple interest, earned only on the original $100, it would be $225 after 25 years (our calculation). The difference is the interest earned on interest.
Divide 72 to see when it doubles.
Divide 72 by the interest rate to estimate how many years it takes to double.
Estimated time for money to double at 9% a year
A rule-of-72 estimate. Actual rates can change.
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The rule of 72
Divide 72 by the annual rate to estimate how many years it takes for money to double. At 9% a year, 72 ÷ 9 gives about 8 years.[1]
The same calculation also estimates how long it takes rising prices to halve the value of money.
It works on borrowing too.
Compounding also works on the interest charged on money you borrow.
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Daily compounding
The US Consumer Financial Protection Bureau (CFPB) explains that credit card interest is calculated by multiplying a daily periodic rate by the amount owed at the end of each day, and that this interest is added to the previous day’s balance — so interest compounds daily.[2]
Two directions
On money you save, compounding works for you; on money you borrow, the same mechanism makes the burden grow. The CFPB describes compound interest as earning interest on the money you have saved and on the interest you earn along the way.[3]
A scale for reading time.
A scale for reading compound interest.
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The rate
What the annual rate is. Even a rate that looks small opens a gap over the years.[1]
The years
How long it continues. Compounding works with time.[1]
The direction
Is it money you save, or money you borrow?[2]
This is not advice
This edition explains how compound interest works. It does not recommend any deposit, investment or borrowing. Interest and returns are not promised.
Next question
NEXT QUESTIONThe same dollar grows a little lighter.NEXT QUESTIONThe deepest tap in money.See the Field Notes shelf →What this edition cannot tell you
- Actual returns on deposits or investments. They change with time and product, and are not promised.
- National rules on interest charged on borrowing.