Key insights:
- Compound interest is the interest you earn on both your original deposit and the interest that accumulates over time
- You could calculate compound interest using a standard mathematical formula or an online calculator
- Accounts that compound interest daily or monthly may help your balance grow faster than accounts with only simple interest
- Many financial products use compounding, including savings accounts and certificates of deposit
Suppose you deposit money into a new savings account and leave it there for a few years. When you check your balance later, you might be pleasantly surprised to see it has grown by more than you expected. This growth is usually a result of compound interest, which is the interest you earn on your principal amount as well as on the interest that accumulates over time.
Let’s take a deeper look at how compound interest works, including some example calculations and the types of bank accounts that may use it.
How does compound interest work?
Compound interest works by adding the interest you earn back into your principal balance, meaning your future interest is calculated on a slightly larger amount each time. Assuming no fees, additional deposits or withdrawals, and the interest rate remains the same for the entire year. You could calculate interest on a bank account balance using the following formula:
[A = P (1 + r/n) (nt)]
- Principal amount (P): The initial amount of money you deposit into your account
- Rate (r): The annual interest rate expressed as a decimal
- Number of compounding periods (n): How many times the interest is compounded per year
- Time (t): The number of years the money is left to grow
- Total amount (A): The future value of your account after the interest is applied
For example, say you deposit $10,000 in a savings account that earns a 2.3% annual rate of return. Using the compound interest formula to calculate, after 1 year, you could end up with as much as $10,230 in a savings account.
What if you save that $10,000 for 5 years instead? That initial deposit could grow by more than $1,200 through compounding at a 2.3% annual rate.
If you really want to reap the advantages of compound interest, consider the potential impact of regular contributions. For example, by contributing $100 per month to your savings, it may grow to $17,486.55 after 5 years at that 2.3% annual rate of return.
Compound interest vs. simple interest
Simple interest is calculated only on the principal you deposit into a savings account. Compound interest is calculated on the principal plus any previously earned interest. Because the base amount increases every time interest is applied, compound interest could help your balance grow much more over a long period.
Here’s a look at the growth of interest compounded annually and simple interest after 30 years, starting with the same initial investment of $10,000 at a 5% interest rate:
Year |
Simple Interest Balance |
Compound Interest Balance |
1 |
$10,500 |
$10,511 |
5 |
$12,500 |
$12,763 |
10 |
$15,000 |
$16,289 |
15 |
$17,500 |
$20,789 |
20 |
$20,000 |
$26,533 |
25 |
$22,500 |
$33,863 |
30 |
$25,000 |
$43,219 |
From the table above, you can see a significant difference between simple and compound interest growth over time.
Types of financial accounts that use compound interest
Compound interest could play a role in how a variety of accounts may help you grow your funds over time. Here’s how it applies in different financial settings.
Savings accounts
Some Savings accounts may compound interest daily, and others may compound monthly, depending on the bank and the product. While interest rates may be modest, the compounding frequency could help your savings grow steadily.
Certificates of deposit (CDs)
CDs may offer higher interest rates than regular savings accounts, and the frequency of compounding interest varies by bank and account, it could be daily or monthly. Because your money is locked in for a fixed term, interest could build more substantially, especially with longer terms.
