Making Sense of Compound Interest
My grandfather kept his savings in a regular bank account for 40 years. When he finally looked at what he had versus what he could have had in a higher-yield account, the difference was enough to buy a car. That's compound interest in action, working either for you or against you.
The Basic Idea
Simple interest pays you only on your original deposit. If you put $1,000 in an account earning 5% simple interest, you get $50 per year forever. After ten years, you've earned $500 in interest.
Compound interest pays you on your original deposit plus all the interest you've already earned. That same $1,000 at 5% compounded annually becomes $1,050 after year one. Year two, you earn 5% on $1,050, giving you $1,102.50. After ten years, you have $1,628.89, not $1,500.
The difference gets more dramatic over longer periods. Play with the numbers in our Compound Interest Calculator to see how time amplifies small advantages.
Why Small Rates Matter
A 1% difference in interest rate seems trivial. On $10,000 over one year, it's only $100. But over 30 years of retirement savings, that 1% compounds into tens of thousands of dollars.
This is why financial advisors obsess over expense ratios in investment funds. A fund charging 0.1% versus one charging 1% might seem like a rounding error. Over a career of investing, that 0.9% difference can mean retiring years earlier or with significantly more money.
Working Against You
Credit card interest compounds too, and not in your favor. A $5,000 balance at 20% interest, making only minimum payments, takes about 22 years to pay off. You'd end up paying over $9,000 in interest alone.
This is why high-interest debt should be eliminated before focusing on low-return savings. Paying off a 20% credit card is like getting a guaranteed 20% return on your money. No savings account offers anything close to that.
The Frequency Factor
How often interest compounds matters too. Monthly compounding beats annual compounding because you start earning interest on your interest sooner. Daily compounding beats monthly by a smaller margin.
Most banks advertise the APY, annual percentage yield, which accounts for compounding frequency. This makes it easier to compare accounts with different compounding schedules.
Starting Early
The most powerful variable in the compound interest equation is time. Someone who starts saving at 25 and stops at 35, then never adds another dollar, can end up with more than someone who starts at 35 and saves until 65. Those extra ten years of early contributions compound for so long that they outpace decades of later contributions.
This isn't about being rich young. It's about giving whatever you can save the maximum time to grow. Even small amounts saved early have enormous advantages over larger amounts saved later.
Understanding compound interest changes how you see both saving and borrowing. It's not magic, just math. But it's math that, given enough time, produces results that feel almost magical.