See how your investments grow over time with the power of compound interest. Calculate future values with our easy-to-use calculator.
Compound interest is often called "the eighth wonder of the world" because of its powerful ability to grow your money exponentially over time. Unlike simple interest, which only earns interest on the principal amount, compound interest earns interest on both the principal and any accumulated interest.
With compound interest, the interest you earn gets added to your principal, so that the balance doesn't just grow – it grows at an increasing rate. This is what makes compound interest so powerful for long-term investments.
A = P(1 + r/n)^(nt)
The true power of compound interest becomes evident over longer time periods. This is why starting to invest early is so important. Consider these key benefits:
Consider two investors:
Investor A invests $5,000 at age 25 and adds $200 monthly until age 65 (40 years), earning 7% annually.
Investor B starts at age 35, invests $15,000 initially, and adds $400 monthly until age 65 (30 years), also earning 7%.
Despite Investor B contributing more in total ($159,000 vs. $101,000), Investor A ends up with significantly more money ($607,000 vs. $546,000) thanks to the extra decade of compound growth.
Simple interest is calculated only on the principal amount, regardless of how long the money has been invested. For example, if you invest $1,000 at 5% simple interest, you'll earn $50 per year, every year.
Compound interest, however, is calculated on both the principal amount and the accumulated interest over time. This means your money grows exponentially. In the same example, at 5% compound interest, you'd earn $50 in the first year, but in the second year, you'd earn 5% on $1,050, which is $52.50, and so on.
The compounding frequency refers to how often the interest is calculated and added to your principal. The more frequently interest is compounded, the more you'll earn over time.
For example, if you have $10,000 invested at 5% annual interest for 10 years:
- Annual compounding: $16,289
- Monthly compounding: $16,470
- Daily compounding: $16,487
While the difference might seem small in shorter time periods, it becomes more significant over longer periods or with higher interest rates.
Regular contributions significantly accelerate the growth of your investment through compound interest. Each contribution starts its own compounding journey, and over time, these regular additions combined with compounding can lead to substantial growth.
For example, $10,000 invested with 7% annual return for 30 years would grow to about $76,123. But if you add just $100 monthly during that period, your final balance would be approximately $142,765 - nearly twice as much.
Several types of investments and accounts offer compound interest:
- Savings accounts
- Certificates of Deposit (CDs)
- Money market accounts
- Bonds (when interest payments are reinvested)
- Dividend-paying stocks (when dividends are reinvested)
- Index funds and mutual funds (when distributions are reinvested)
- Retirement accounts like 401(k)s and IRAs
The key to maximizing compound interest is to reinvest earnings rather than withdrawing them.
In most cases, compound interest earnings are taxable in the year they are received or credited to your account, even if you don't withdraw the money. The specific tax treatment depends on the type of investment:
- Interest from savings accounts, CDs, and bonds is typically taxed as ordinary income
- Qualified dividends and long-term capital gains often receive preferential tax rates
- Tax-advantaged accounts like 401(k)s and traditional IRAs allow your earnings to compound tax-deferred until withdrawal
- Roth IRAs and Roth 401(k)s offer tax-free growth if certain conditions are met
Always consult with a tax professional for advice specific to your situation.
The Rule of 72 is a simple formula that quickly estimates how long it will take for an investment to double in value at a given fixed annual rate of interest. You divide 72 by the annual rate of return to approximate the years required for doubling.
For example:
- At 4% interest, money doubles in approximately 18 years (72 ÷ 4 = 18)
- At 8% interest, money doubles in approximately 9 years (72 ÷ 8 = 9)
- At 12% interest, money doubles in approximately 6 years (72 ÷ 12 = 6)
This rule provides a quick mental calculation without needing to use logarithms or complex formulas.
Several factors can diminish the power of compound interest:
- Fees and expenses: Investment fees, even small ones, can significantly reduce your returns over time
- Taxes: Paying taxes on earnings reduces the amount that can be reinvested and compounded
- Inflation: While your money may grow in nominal terms, inflation reduces its purchasing power
- Early withdrawals: Taking money out reduces the principal amount that can generate future returns
- Market volatility: Negative returns in some years can set back your compound growth
To maximize compound interest, minimize fees, consider tax-advantaged accounts, stay invested for the long term, and maintain realistic return expectations.