Compound Interest Explained: The Most Powerful Force in Finance
Compound interest is interest earned on both your original principal and on previously accumulated interest. It's the reason why starting to save early makes such a dramatic difference in your final wealth.
Simple vs. Compound Interest
Simple interest is calculated only on the original principal. If you invest $10,000 at 5% simple interest, you earn $500 every year — always $500, regardless of how long you invest.
Compound interest includes interest on the interest. That same $10,000 at 5% compounded annually earns $500 the first year, $525 the second year, $551.25 the third year, and so on. The growth accelerates over time.
The Compound Interest Formula
A = P(1 + r/n)^(nt)
- A = Final amount
- P = Principal
- r = Annual interest rate (decimal)
- n = Compounding frequency per year
- t = Time in years
The Power of Time
Consider two investors who each invest $5,000 per year at 7% return:
- Investor A starts at age 25 and invests for 10 years (stops at 35): Total invested = $50,000. Value at 65 = ~$602,000.
- Investor B starts at age 35 and invests for 30 years (until 65): Total invested = $150,000. Value at 65 = ~$505,000.
Investor A invested less money but ended up with more — because those early dollars had more time to compound.
Compounding Frequency Matters
$10,000 at 6% for 10 years:
- Annually: $17,908
- Monthly: $18,194
- Daily: $18,221
More frequent compounding produces slightly higher returns, though the difference shrinks as frequency increases.
See the difference yourself with our compound interest calculator.