Compound Interest: What It Is and How It Works

Compound interest is a method of calculating growth in which interest may be earned not only on the original amount but also on interest that has previously been added to the balance.

What Is Compound Interest?

With compounding, the amount used to calculate future interest can grow over time because previously earned interest may become part of the balance.

How Does Compound Interest Work?

The effect of compounding depends on several factors, including the starting amount, rate of return or interest rate, length of time and how frequently compounding occurs.

If positive returns are added back to the investment or account balance, future growth calculations may apply to a larger amount.

Simple Interest vs Compound Interest

Simple interest generally applies interest calculations to the original principal amount. Compound interest can apply future interest calculations to a balance that includes previously accumulated interest.

• Simple interest: Growth is generally calculated using the original principal according to the applicable terms.
• Compound interest: Growth may be calculated using the original amount plus previously accumulated interest.

The Importance of Time

Time can have a significant effect on compounding because the process may repeat over multiple periods. Longer periods can provide more opportunities for positive growth to compound, although investment returns are not guaranteed.

Compounding can also work in the opposite direction when losses occur. A decline in value reduces the amount on which future growth may occur.

Compounding Frequency

Interest or returns may be compounded at different intervals depending on the product or investment. Examples can include annual, semi-annual, quarterly or monthly compounding.

The effect of compounding frequency depends on the stated rate and other terms. Investors and savers should understand how the specific product calculates and credits interest or returns.

Compounding and Investing

Compounding is often discussed in relation to long-term investing because gains that remain invested may potentially generate additional gains over time.

However, market investments do not provide guaranteed returns. Investment values can fluctuate, and losses may reduce the benefits of positive compounding.

Factors That Can Affect Results

• Starting investment amount.
• Rate of return or interest rate.
• Length of the investment period.
• Frequency of compounding.
• Additional contributions or withdrawals.
• Fees and expenses.
• Taxes where applicable.
• Investment gains and losses.

Common Misunderstandings

Compound interest does not guarantee that an investment will grow. The concept explains how repeated positive growth can build upon previous growth, but actual investment returns can vary and may be negative.

Higher potential returns may also involve higher levels of risk. The expected growth rate used in an illustration may not reflect actual future performance.

Questions to Consider

• What rate of return or interest rate is being used?
• Is the rate fixed, variable or only an illustration?
• How frequently is interest compounded?
• What fees or costs may reduce returns?
• What is the intended time horizon?
• What risks could affect the actual outcome?

Key Takeaways

• Compound interest can involve earning growth on previous growth.
• Time can increase the potential effect of repeated compounding.
• The starting amount, return rate and time period can significantly affect results.
• More frequent compounding can change outcomes depending on the terms.
• Fees, taxes, withdrawals and losses can affect actual results.
• Investment returns are not guaranteed, and compounding does not eliminate investment risk.