Compound interest is one of the most useful ideas in personal finance, and it is simpler than it sounds.
The idea in one sentence
With compound interest, the interest you earn is added to your money, and then that bigger amount earns interest too.
A simple example
Imagine you put 1,000 in a savings account that pays 5% a year, and you never touch it.
- After year 1 you earn 50, so you have 1,050.
- In year 2 the 5% is paid on 1,050, not on 1,000. You earn 52.50, so you have 1,102.50.
- Each year the interest is a little bigger than the year before.
After 10 years you would have about 1,628.89. After 30 years, about 4,321.94.
Compound vs. simple interest
With simple interest, you only earn on the original 1,000. That is 50 every year. After 10 years you would have 1,500, and after 30 years 2,500.
| After | Simple interest | Compound interest |
|---|---|---|
| 10 years | 1,500 | 1,628.89 |
| 30 years | 2,500 | 4,321.94 |
The longer the time, the bigger the difference. Time is the most powerful part of the idea.
The Rule of 72
Want a quick estimate of how long it takes money to double? Divide 72 by the yearly rate.
At 5% a year: 72 ÷ 5 = about 14 years to double. (The exact answer is about 14.2 years, so the rule is a good shortcut.)
It works the other way too
Compound interest also applies to debt. If you owe money on a credit card and only pay a little, the interest is added to what you owe, and then that bigger amount grows. This is why high-interest debt can get out of hand quickly.
What to take from this
- Starting earlier matters more than it seems, because time does most of the work.
- Small regular amounts add up over many years.
- A higher rate helps, but the examples above are only illustrations. Real rates change, and some investments can lose value.
Try the numbers yourself with the compound interest calculator.
A small note: the examples above add interest once a year, to keep the maths easy to follow. The calculator adds interest every month, which is how many savings accounts work, so it gives a slightly higher result (about 1,647 instead of 1,629 for the first example, with no monthly saving).