How does compound interest work?
Quick answer
Compound interest means you earn interest on both your original principal and on previously earned interest, so growth accelerates over time. $10,000 at 7% grows to $10,700 in year one, but year two adds $749 because the 7% applies to the larger balance. Over 30 years it becomes about $76,000 — without adding a cent.
Simple interest pays only on your original deposit: $10,000 at 7% simple interest earns a flat $700 every year. Compound interest reinvests each interest payment, so the base keeps growing. The formula is A = P(1 + r/n)^(nt), where P is principal, r the annual rate, n the number of compounding periods per year, and t the years. The exponent is why growth curves upward instead of rising in a straight line.
Compounding frequency matters, but less than people expect. $10,000 at 7% for 10 years grows to $19,672 compounded annually, $20,016 compounded monthly, and $20,137 compounded daily. The rate and the time horizon dominate; the frequency fine-tunes. Watch for APY (which includes compounding) versus nominal APR when comparing savings accounts.
Time is the most powerful variable. Someone who invests $200 per month at 7% from age 25 to 35 and then stops (contributing $24,000 total) ends up with more at 65 than someone who invests $200 per month from 35 to 65 (contributing $72,000). The extra decade of compounding outweighs three times the contributions. This is why starting early — even with small amounts — matters more than starting big.
The Rule of 72 gives a quick mental estimate: divide 72 by the annual return to get the doubling time. At 8%, money doubles roughly every 9 years; at 6%, every 12 years. Over a 36-year career at 8%, each dollar invested at the start doubles four times into about $16.
Compounding also works against you: credit card debt at 22% APR doubles in about 3.3 years if unpaid, and inflation quietly compounds the cost of living. Use a compound interest calculator to see how your own principal, monthly contributions, rate, and timeline play out year by year.
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