What Is Compound Interest—And How Does It Work?

Compound interest is powerful. It’s been called the eighth wonder of the world. Why? The magic of compounding can help you grow both savings account balances and investments over time.

For savings accounts this benefit is called compound interest. For investments, like mutual funds, it can also be called compound earnings. But the concept is the same.

We dig deeper into how compounding can impact your investments, starting with what it is and how it works.

What Is Compound Interest?

Compound interest is essentially interest on interest.

What does that mean? When you invest money, you earn interest on the initial amount. Over time that interest earns interest, too.

Compounding Helps Your Money Work Harder

Source: American Century Investments.

This hypothetical situation contains assumptions that are intended for illustrative purposes only and are not representative of the performance of any security. There is no assurance similar results can be achieved, and this information should not be relied upon as a specific recommendation to buy or sell securities.

Depending on the situation, compound interest might be calculated daily, monthly or annually. Over long periods of time, this might help you increase your initial balance.

How Does Compound Interest Work?

Here’s an example of compound interest in action.

Let’s say you start with $1,000 in a mutual fund account. Then you add $100 each month.

After 10 years, you will have put $13,000 in the account. Assuming a 6% return compounded annually, however, you’ll have $18,117 in the account.

After 20 years, you will have put in $25,000, but the account balance will be $48,772. That’s almost twice the principal amount you actually contributed.

Source: American Century Investments; Compound Savings Calculator from Dinkytown.net, August 2021.

This hypothetical situation contains assumptions that are intended for illustrative purposes only and are not representative of the performance of any security. There is no assurance similar results can be achieved, and this information should not be relied upon as a specific recommendation to buy or sell securities.

The Negative Side of Compound Interest

Compound interest can also be a factor in loans. But in this context, it’s not favorable to borrowers.

Student loans, mortgages and personal loans generally use compound interest. That means that the loan balance is calculated based on the amount you borrowed plus interest.

The longer you take to pay the loan back, the more the balance can grow. That’s why even when you make payments, your account can sometimes be larger than the amount you initially borrowed.

It’s often smart to focus on paying off high-interest loans before other debt.

Compound Interest vs. Simple Interest

Compound interest isn’t the only way to calculate interest. There’s also simple interest. This is when interest is calculated only on the original balance.

Simple interest is more favorable to borrowers because their balance grows more slowly. But it’s less favorable for investors for the same reason. With simple interest, they don’t earn interest on interest.

How Does Compounding Help Your Investments?

Investments like stocks and bonds don’t earn interest the same way a savings account does. When we talk about compounding for these types of assets, we mean compounding investment returns.

For instance, say you have a stock mutual fund that earns dividends. You could choose to receive those dividends in cash. Or you could reinvest them.

If you reinvest the dividends, your returns will compound over time. That's because you'd be positioned to earn money on your investment earnings. Depending on how the market performs, you’d ideally have a bigger pot of money in the long run.

Compounding can be a useful tool to help you reach your long-term financial goals over time, especially if you keep adding to your investments, known as automatic investing.