How does compound interest work?

Compound interest means you earn interest on your interest, so your money grows on a bigger base each year. The longer it has to work, the more of your final balance comes from growth instead of from what you put in.

Growth earns growth

Each year's interest or return is added to the balance. Next year, you earn on the original amount plus everything it already earned. That snowball effect is compounding.

Time matters more than the amount

Money saved in your 20s has decades to compound. In the examples on this page, starting 10 years earlier more than doubles the balance at 65, with only $24,000 more put in.

Returns are assumptions

Savings accounts pay a stated rate that can change. Investments like stock index funds have no set rate. Their returns vary from year to year and can be negative. The examples here assume a steady rate to show the math.

The rule of 72 gives a quick estimate

Divide 72 by the yearly rate to estimate how many years it takes money to double. At an assumed 6% a year, 72 ÷ 6 = 12 years.

Simple interest vs compound interest

Simple interest is paid only on the money you put in. Put $1,000 in at 7% simple interest and you earn $70 every year. After 10 years you have $1,000 + 10 × $70 = $1,700.

Compound interest is paid on the balance, which includes past interest. At 7% a year, compounded monthly, the same $1,000 grows to about $2,010 in 10 years. Year 1 adds about $72, and by year 10 each year adds well over $100, because the base keeps getting bigger.

The same math works against you on debt. A credit card balance you don't pay off compounds too, which is why high-interest debt usually comes before investing.

Interest and returns are not the same thing

A savings account or certificate of deposit pays interest at a stated rate. The rate on a savings account can change, but the balance doesn't drop.

Stocks and stock funds don't pay a set rate. Their value goes up and down, and some years it falls. When people say an investment compounds, they mean gains are left in to grow along with the original money. Over long periods that can add up, but no rate is promised, and any single year can be a loss.

When you see a long-term projection, treat the rate as a guess. This page assumes 7% a year for most examples. That is an assumption for teaching, not a forecast, and it is before inflation, taxes and fees.

Why starting early matters so much

Compounding is slow at first. In the first year of saving $200 a month at an assumed 7%, growth adds less than $80. The big gains come late, when the balance is large and has had decades to build.

That is why the years you give it matter more than any one deposit. Someone who starts at 25 and someone who starts at 35 may save the same $200 a month. The earlier start gets 10 more years of compounding on top, and those last years are when growth is largest.

Starting late still works. It means saving more each month to reach the same place, so the best time to start is with whatever you can afford now, even $25.

The rule of 72

To estimate how long money takes to double, divide 72 by the yearly rate. At 8% it is 72 ÷ 8 = 9 years. At 4% it is 72 ÷ 4 = 18 years.

It is a shortcut, not exact math, but it is close for rates between about 4% and 10%. The table on this page compares the estimate with the exact answer.

Inflation, fees and taxes

Prices tend to rise over time, so a dollar in 30 years will buy less than a dollar today. A projection of $250,000 in 30 years is worth less in today's money. The real return is roughly your return minus inflation.

Fees and taxes also come out of growth. A fund fee of 1% a year sounds small, but it is taken every year from a growing balance, so it compounds against you. Tax-advantaged accounts, such as a 401(k) or IRA, can delay or avoid some taxes on growth. The rules depend on the account and your income, so check IRS guidance for your situation.