Compound interest explained simply
Compound interest sounds technical, but the idea is friendly: you earn interest on your savings, and then that interest earns interest too. Over a short time the effect is small. Over a long time it is surprisingly large.
Simple versus compound
With simple interest, 5% on $1,000 gives $50 every year, forever. With compound interest, year one gives $50, but year two earns 5% on $1,050, which is $52.50, and so on. The growth accelerates a little each year.
| Year | Simple (5%) | Compound (5%) |
|---|---|---|
| 0 | $1,000 | $1,000 |
| 10 | $1,500 | $1,629 |
| 20 | $2,000 | $2,653 |
| 30 | $2,500 | $4,322 |
The rule of 72
A handy shortcut: divide 72 by the yearly rate to estimate how many years it takes to double. At 6%, 72 รท 6 = 12 years. At 9%, about 8 years. It is an approximation, but a good one for rates between about 2% and 15%.
Why starting early beats starting big
Two savers each put away $200 a month at 5%. One starts at 25 and stops at 35, a total of $24,000. The other starts at 35 and continues to 65, a total of $72,000. Which ends up with more at 65? In this case the later saver does, but not by as much as you would expect given they put in three times the money. The early saver's decade of deposits had 30 years to compound. Time does a lot of work.
How often interest compounds
Interest may be added daily, monthly or yearly. More frequent compounding gives slightly more. Our savings calculator assumes monthly, which is common for savings accounts.
What to remember
- Regular deposits matter. Many people grow wealth mostly by adding steady amounts, not by one big deposit.
- Fees eat growth. A 1% yearly fee compounds against you too.
- Inflation reduces what money can buy. A 5% return with 3% inflation is about 2% real growth.
- Returns are not guaranteed. Savings rates change, and investments rise and fall.
Plug in your own numbers with the savings growth calculator.