What Is Compound Interest?

Compound interest, often called “interest on interest,” occurs when earned interest is added to your original investment (principal), allowing future growth to accelerate as interest is calculated on both the principal and accumulated interest. This creates a snowball effect, making your money grow faster over time compared to simple interest (calculated solely on the principal).

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Compound Interest vs. Simple Interest

• Simple Interest: Earns a fixed amount annually based only on the principal.
  Example: 1,000at51,000at5250 total interest.
• Compound Interest: Earns interest on both principal and accumulated interest.
  Example: 1,000at51,000at5276.28 total interest.

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The Power of Compound Interest

A $1,000 investment at 10% annually for 20 years:

• Compound Interest: Grows to $6,727.50.
• Simple Interest: Grows to $3,000.
• No Interest: Remains $1,000.

Warren Buffett attributes much of his success to compound interest:
“My wealth has come from a combination of living in America, some lucky genes, and compound interest.”

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Strategies to Maximize Compound Interest

1. Start Early: Time amplifies growth. A 200monthlyinvestmentat7200monthlyinvestmentat7525,000 by age 65.
2. Contribute Regularly: Adding 100monthlytoa100monthlytoa10,000 investment at 5% over 20 years boosts the final amount to $67,121.
3. Choose Frequent Compounding: Interest compounded monthly grows slightly faster than annually.

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How to Calculate Compound Interest

Formula:A=P(1+rn)ntA=P(1+nr​)nt

• A = Future value
• P = Principal
• r = Annual interest rate (decimal)
• n = Compounding periods per year
• t = Time in years

Example:
$10,000 at 5% annually for 20 years:A=10,000(1+0.051)1×20=$26,532.98A=10,000(1+10.05​)1×20=$26,532.98

Total Interest: $16,532.98 (165% return).

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Real-World Growth with Regular Contributions

Adding 100monthlytoa100monthlytoa10,000 investment at 5% over 20 years:

• Total Deposits: $34,000
• Final Value: $67,121
• Interest Earned: $33,121

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Where to Invest for Compound Growth

• High-Yield Savings Accounts: Low risk, steady returns.
• Retirement Accounts (401(k), Roth IRA): Tax advantages amplify growth.
• Stocks/ETFs: Higher risk but potential for greater returns.

Always consult a financial advisor to align choices with your goals.

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FAQs

1. When is interest compounded?
Interest can compound daily, monthly, quarterly, or annually. More frequent compounding slightly boosts growth.

2. Can I include withdrawals?
Yes. Use a calculator to model withdrawals (e.g., retirement income).

3. What is the effective annual rate (EAR)?
The actual annual return after compounding. For example, 5% compounded monthly has an EAR of 5.12%.

4. What is Time-Weighted Return (TWR)?
Measures investment performance excluding deposits/withdrawals, giving a clearer growth picture.

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Final Thoughts

Compound interest is a cornerstone of wealth-building. By starting early, investing consistently, and choosing the right vehicles, you harness its power to grow savings exponentially. Use online calculators to model scenarios and consult professionals to optimize your strategy.

Use our free compound interest calculator to evaluate how your savings or investments might grow over time, with or without regular contributions. Our tool helps you see how compound interest can increase the value of your money as you plan for the future. Got questions?

1. Start Early: Time plays an important role in compound interest. So, starting your investments early, even with smaller amounts, gives your money more time to grow and for the interest to compound.
2. Regular Contributions: By consistently adding to your investment, you enhance the compounding effect (think about the analogy of a snowball). Each new contribution starts earning its own interest, adding to the overall growth.
3. Higher Compounding Frequencies: When evaluating savings or investment options, pay attention to those that compound more frequently. The more often interest is compounded, the greater the potential for growth—although the difference may be minimal at lower interest rates.