Finance term
Compound Interest
Also known as: compounding, interest on interest
Definition
Compound interest is interest calculated on both the initial principal and the accumulated interest from prior periods. On savings and investments, compounding grows wealth exponentially. On debt, compounding accelerates the balance owed — making early repayment especially valuable.
Detailed explanation
The compound interest formula is: A = P(1 + r/n)^(nt), where P is principal, r is annual interest rate, n is compounding periods per year, and t is years. The more frequently interest compounds (daily vs. monthly vs. annually), the higher the effective yield or cost.
On savings accounts and high-yield savings, the APY (Annual Percentage Yield) reflects the effective return after compounding — always compare APY, not just the stated rate, when evaluating deposit products. Daily compounding on $10,000 at 5% produces a slightly higher return than annual compounding at the same stated rate.
On credit card debt, compounding works against the borrower. Most cards compound daily: your statement balance unpaid from last month has interest added each day, and that added interest itself earns more interest. The CFPB's Truth in Lending Act disclosures (Regulation Z) require issuers to disclose the APR in a way that reflects this compounding burden. Albert Einstein is often (likely apocryphally) attributed with calling compound interest 'the eighth wonder of the world' — whether on a savings account or a debt balance, the math is consistently dramatic over time.
◈ Worked example
- $10,000 at 5% compounded annually for 30 years = $43,219. The same amount at 5% compounded daily = $44,812 — compounding frequency matters.
- Carrying a $5,000 credit card balance at 22% APR (compounded daily) for 5 years without paying it down grows to approximately $14,800.
Common questions
The most-asked questions about Compound Interest — answered straightforwardly.
What's the difference between simple and compound interest? +
Simple interest is calculated only on the original principal. Compound interest is calculated on principal plus accumulated interest. Most financial products — savings, investments, loans, credit cards — use compound interest.
How often does compound interest compound? +
Depends on the product. Savings accounts and credit cards typically compound daily. CD interest often compounds daily but pays at maturity or monthly. Bonds typically pay simple interest semi-annually. Always check the APY/APR for the effective cost or return after compounding.
Further reading
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