Compound interest is interest earned on your original money and on the interest it has already earned. It works for savers and against borrowers.
A simple example
Deposit $1,000 at 5% a year. After year one you have $1,050. In year two, interest is paid on $1,050, giving $1,102.50. In year three, $1,157.63. With simple interest you would earn a flat $50 each year and have $1,150 after three years. The gap is small at first and grows quickly.
The formula
A = P × (1 + r ÷ n)n × t, where P is the starting amount, r the annual rate, n the number of compounding periods per year and t the years.
The Rule of 72
Divide 72 by the annual rate to estimate how many years it takes to double. At 6%, about 12 years; at 9%, about 8.
What changes the outcome
- Time is the biggest factor. Starting earlier helps more than most people expect.
- Rate compounds too; small differences add up.
- Contributions add to the base that earns interest.
- Fees and inflation reduce your real return.
The other side
Credit cards compound against you. A balance carried month to month grows on interest charged on interest. Try the compound interest calculator with and without monthly contributions, and see the effect of inflation with the investment calculator.