What is compound interest?
Compound interest is interest calculated on both your original principal and the interest already earned — so your balance grows faster over time because each period's interest earns interest in the next.
The CFPB defines compound interest as earning interest on both the money you've saved and the interest you earn along the way. The result is exponential growth: the longer money compounds, the faster the balance accelerates — without any additional deposits.
Compound vs. simple interest
- Simple interest: Calculated only on the original principal. $1,000 at 5%/yr earns $50 every year, always on the original $1,000.
- Compound interest: Calculated on principal plus accumulated interest. The same $1,000 at 5% earns $50 in year 1 ($1,050), then $52.50 in year 2 (5% of $1,050) — $1,102.50 total, without adding a dollar.
How compounding frequency affects growth
Interest can compound annually, quarterly, monthly, or daily. The more frequently it compounds, the more interest is added to the principal each period — and the faster the balance grows, all else equal. A savings account compounding daily accumulates slightly more than one compounding monthly at the same stated rate.
Where compound interest shows up
- Savings accounts and CDs: Earns compound interest in your favor.
- Retirement and investment accounts: Returns can compound over decades.
- Debt (credit cards, loans): Compounding works against you when balances aren't paid off — unpaid interest is added to principal, increasing what future interest is calculated on.
Compound interest facts
- Compound interest is when you earn interest on the money you've saved and on the interest you earn along the way. — CFPB — How does compound interest work?
- CFPB example: $1,000 at 5% annual interest grows to $1,050 after year 1 and $1,102.50 after year 2 through compounding. — CFPB
- Savers can accelerate compound growth by increasing compounding frequency, finding a higher rate, and adding to principal. — CFPB
Key takeaways
- Compound interest earns interest on both principal and previously earned interest — accelerating growth over time.
- More frequent compounding produces slightly higher effective returns at the same stated rate.
- Compounding works for you in savings/investments and against you in debt that carries a balance.
- Time is the most powerful variable — more compounding periods produce dramatically larger balances.
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