Some people like to refer to the principle of compound interest as magical – and while it's not magical, it is a pretty cool mathematical principle.
Because the potential effect on your savings can be so dramatic, it seems to defy natural law.
Compound interest is what happens when the interest you earn on savings begins to earn interest on itself. As interest grows, it begins accumulating more rapidly and builds at an exponential pace.
How compound interest works
Imagine you contribute $1,000 to a hypothetical investment that earns eight percent annually.
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).
Let's do the math for the second year of your account.
- Starting value is $1,080 (your principal and interest from Year 1)
- + $1,000 (your Year 2 principal contribution)
- = $2,080 (Year 1 total + Year 2 principal)
- + $166.40 (8 percent of $2,080, your Year 2 interest)
- = $2,246.40 (your new total balance)
Now, we'll repeat the same formula for the third year.
- Starting value is $2,246.40
- + $1,000 (your Year 3 principal contribution)
- = $3,246.40 (Year 2 total + Year 3 principal)
- + $259.71 (8 percent of $3,246.40, your Year 3 interest)
- = $3,506.11 (your new total balance)
See how things can add up quickly? That's the power of compounding!
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.
Years of saving $1,000 annually