Compound interest is interest calculated on both the initial principal and the accumulated interest from previous periods. As interest grows, it begins accumulating more rapidly and builds at an exponential pace. The potential effect on your savings can be dramatic.

The standard formula for compound interest is:

A = P(1 + r/n)^(nt)

Where:

• A = Final amount
• P = Principal (initial investment)
• r = Annual interest rate (as a decimal)
• n = Number of times interest compounds per year
• t = Number of years

Compound interest vs. simple interest

Unlike compound interest, simple interest is calculated only on the original principal. Over time, compound interest generates significantly higher returns because you earn interest on your accumulated interest. For example, $1,000 at 8% simple interest earns $80 annually, while compound interest earns progressively more each year.

Key factors that affect compound interest growth

• Principal amount — The initial sum you invest or save
• Interest rate — The percentage return on your investment
• Compounding frequency — How often interest is calculated (daily, monthly, quarterly, or annually)
• Time horizon — The length of time your money remains invested

How compounding frequency impacts growth

Interest can compound at different intervals, and more frequent compounding leads to greater returns:

• Daily compounding — Interest calculated every day (365 times per year)
• Monthly compounding — Interest calculated 12 times per year
• Quarterly compounding — Interest calculated 4 times per year
• Annually compounding — Interest calculated once per year

The more frequently interest compounds, the faster your money grows.

How compound interest works

Imagine you contribute $1,000 to a hypothetical investment that earns eight percent annually (based on historical stock market average returns).

After the first year, your balance is $1,080.

The next year, you contribute another $1,000 and earn eight percent again — not only on your contributions (called the "principal") of $2,000, but also on the interest from the first year ($80).

See how things can add up quickly? That's the power of compounding!

The Rule of 72

A quick way to estimate how long it takes to double your money is the Rule of 72. Simply divide 72 by your annual interest rate. For example, at 8% interest, your money doubles in approximately 9 years (72 ÷ 8 = 9).

The effect of compound interest over time

In the early years of saving, it may seem like you're earning only a modest amount of interest, but give it time.

With each passing year, your compounding interest grows exponentially until it exceeds your principal and is responsible for most of the growth in your account.

The chart below is based on our examples above and shows what the combination of time and compound interest can potentially do.

Key takeaways

• Start early — The longer your money compounds, the greater your returns
• Time is your greatest asset — Compound interest grows exponentially over time
• Compounding frequency matters — More frequent compounding leads to higher returns
• Consistency pays off — Regular contributions amplify the power of compounding
• Understand the difference — Compound interest outperforms simple interest significantly over time