What Is Compound Interest and Why Does It Matter?
Understand compound interest in plain English, how it differs from simple interest, and why starting to save early makes such a dramatic difference.
Compound Interest in Plain English
Compound interest means you earn interest on your interest. When you put money in a savings account or investment, you earn a return. The next time interest is calculated, it is based on your original amount plus all the interest you have already earned. Over time, this creates a snowball effect where your money grows faster and faster.
Imagine you put $1,000 in an account that earns 5% per year. After one year, you have $1,050. In year two, you earn 5% not on $1,000 but on $1,050, giving you $1,102.50. By year ten, that $1,000 has grown to $1,629 without you adding a single extra dollar. The math is not dramatic in year one or two, but it becomes powerful over many years.
The key variables are the interest rate, the compounding frequency (daily, monthly, or annually), and time. Time is the one most people underestimate. The longer compound interest works, the more dramatic the results.
Simple vs Compound Interest
Simple interest is calculated only on the original amount you deposited or borrowed. If you put $1,000 in an account earning 5% simple interest, you earn exactly $50 per year, every year, no matter how long the account has been open.
Compound interest, by contrast, calculates interest on the growing balance. The same $1,000 at 5% compounded annually earns $50 in year one, $52.50 in year two, $55.13 in year three. The yearly amount keeps climbing even though the rate never changes.
For savers and investors, compound interest is a powerful ally. For borrowers, it is the reason a credit card balance that seems small can grow into a serious burden if left unpaid. The same math that works for you in savings works against you in debt.
The Power of Starting Early
The most important lesson about compound interest is that time matters more than the amount you start with. Consider two people: one starts investing $200 per month at age 25 and stops at age 35, contributing $24,000 total. The other starts at age 35 and invests $200 per month until age 65, contributing $72,000 total. Assuming 7% annual returns, the early starter ends up with more money at 65, despite contributing three times less.
This is the reason financial advisors say to start saving for retirement as soon as possible, even if the amounts are small. A $50 monthly contribution at age 22 will grow into something substantial by age 62. Waiting until you feel rich enough to invest means missing decades of compounding.
The concept has a popular nickname among financial writers: the eighth wonder of the world, a phrase often attributed to Albert Einstein. Whether he said it or not, the idea is sound. Compound interest rewards patience more than almost anything else in personal finance.
Where Compound Interest Works Against You
Credit card companies love compound interest. When you carry a balance, interest is often compounded daily. That means your balance grows slightly every single day, not just at the end of the month. A $5,000 balance at 22% APR costs roughly $1,100 in interest per year if you pay nothing toward it, and that interest then gets added to the balance, creating a cycle.
Payday loans take this even further. Their short loan terms and high fees translate to astronomical effective annual rates. What looks like a $15 fee on a $100 two-week loan equals nearly 400% APR when annualized. Compound interest at those rates is devastating.
The practical takeaway is straightforward: use compound interest aggressively on the savings and investment side of your life, and eliminate high-interest debt as quickly as possible so the compounding effect cannot work against you.