What is compound interest?

Compound interest is interest that’s earned or charged on top of existing interest and principal. This compounding effect can help money grow faster over time—or increase debt by adding to existing balances.

What you’ll learn:

• Compound interest is interest calculated on both the principal and previous interest.

• Compound interest is different from simple interest, which is only applied to the principal.

• Compound interest can help savers and investors earn money.

• Compound interest can increase debt for borrowers.

Compound interest is earned or charged on top of existing interest and principal. When compound interest is applied to savings or investments, it can help that money grow over time. When applied to debt, it can work in reverse and increase what’s owed.

Compounding interest periods refer to how often interest is calculated and added to your balance. Compounding periods can be continuous, daily, monthly, quarterly, semiannual, annual or at other regular intervals. 

In general, the more compounding periods there are, the more the interest grows. This applies whether you’re earning interest or accumulating debt.

Simple interest differs from compound interest. Simple interest is calculated based on the principal only. Compound interest is calculated on both the principal and any previously accumulated interest. A compounded interest account tends to grow at a faster rate than a simple interest account.

There are online calculators that can help you calculate compound interest. The Securities and Exchange Commission offers one example. But if you want to do the calculation the old-fashioned way, here’s the formula for compound interest:

A = P(1 + r/n)nt 

In this formula:

• A is the total future value of the account. 

• P is the principal amount. 

• r is the interest rate in decimal form. 

• n is the number of times the interest compounds per compounding period. 

• t is the total length of time of the investment or loan in years.

If $1,000 is invested in an account with a 5% annual interest rate for 10 years, the calculation would look like this:

$1,000 x (1 + 0.05/1)1x10 = $1,628.89

Using that same example, here’s what would happen if the interest were compounded daily over 10 years instead:

$1,000 x (1 + 0.05/365)365x10 = $1,648.66

So over a 10-year period, the investment would earn $628.89 if the interest were compounded annually, or $648.66 if the interest were compounded daily.

The Rule of 72 is an easy way to estimate how long it could take an initial investment to double in value with an annual rate of return. To use this formula, simply divide 72 by the interest rate.

In the example above, $1,000 was deposited into an account with a 5% annually compounded interest rate. You can divide 72 by 5 to get a value of 14.4 years. That’s about how long it might take the money to double.

Compound interest can apply to savings accounts, investment accounts, credit cards and more. Here’s a closer look.

Compound interest helps savings and investment accounts grow over time because you earn interest on both the original balance and previously earned interest. 

Compound interest will help your savings grow even if you don’t add to the account beyond the initial deposit. But the more you put in, the more interest you can earn and the faster your money can grow.

Compound interest may also apply to credit card accounts. Credit card interest is often compounded daily based on a daily interest rate and the average balance of your account. 

According to Experian, the daily interest rate can be found by dividing the card’s annual percentage rate by 365 or 360, depending on the issuer. 

If you carry a balance from one billing cycle to another, interest can add to what you owe over time. One way to avoid interest on credit card purchases is to pay off the full statement balance on time each month.

If you’re working toward financial goals like planning for retirement or building an emergency fund, compound interest might help you along the way. But it’s also important to remember the role compound interest might have when it comes to debt.

A credit card can be another helpful financial tool to help you along your journey. You can compare Capital One cards.