Compound Interest
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What Is Compound Interest?
Compound interest is interest calculated on both the original principal and the interest that has already been added to a balance. Simple interest, by contrast, is figured only on the starting principal. Because each period's interest is folded back into the balance, the next period's interest is calculated on a slightly larger sum, and the effect builds on itself. The frequency of compounding matters: all else equal, interest that compounds daily produces a larger effective rate than interest compounding annually, because the accumulated interest starts earning interest sooner. Mathematically, a balance left to compound at a steady rate follows an exponential growth curve rather than a straight line. The same mechanism applies whether the account is a savings deposit earning interest or a debt accruing it.
Why It Matters
Compounding is central to how savings and debts change over long horizons. On the saving side, money left invested has more time for returns to compound, which is why starting earlier can matter more than contributing larger amounts later; reinvesting dividends rather than withdrawing them lets those payouts compound as well. On the borrowing side, the same mechanism runs in reverse: a credit-card balance carried at a high APR can grow quickly when only minimum payments are made, because unpaid interest is added to the balance and then itself accrues interest. The annual percentage yield (APY) on a deposit reflects this compounding within a year, whereas a plain nominal rate does not. Understanding the mechanism explains why identical rates can produce very different outcomes.
Test Your Knowledge
Questions on this topic from the EconRecall fact bank:
- What is "compound interest"?
Interest calculated on both the original principal and previously accumulated interest - What is "simple interest," as distinct from compound interest?
Interest calculated only on the original principal amount, not on accumulated interest - All else equal, does more frequent compounding (e.g., daily vs. annually) increase or decrease the effective interest earned or owed?
It increases the effective rate, since interest starts earning interest sooner