What Is Compound Interest? A Guide To Making It Work for You, Not Against You

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A savings account is more than a place to keep your emergency fund. If you leave money in there long enough, it will grow. The money it earns — interest — is free money for you.

Compound interest is the interest paid on the total balance of an account. Unlike simple interest, which is calculated only on your principal — your deposited funds — compound interest includes both the principal and any interest earned on the principal.

Banks don’t quote you a compound interest rate. Instead, the term refers to the way the interest accrues on your account balance.

What Is a Compound Interest Savings Account and How Does It Work?

Compound interest is interest you earn on your principal and any interest previously earned on the principal. It has a snowball effect that grows your savings balance faster the longer you let it grow.

Say you deposit $1,000 in a savings account that earns 5% interest. After one year, you’ll have earned $50 in interest, bringing your balance to $1,050. With a compound interest savings account, that whole balance earns interest in the second year. Instead of earning $50, your money will earn $52.50, bringing your balance to $1,102.50. In year three, you’ll earn $55 in interest on that $1,102.50 balance.

How To Calculate Compound Interest

You can calculate compound interest either by using an online calculator or the annual compound interest equation.

What Is the Compound Interest Formula?

The formula for compound interest is: A = P (1 + r/n)^(nt)

In the formula:

• A is the accrued amount of interest, which is the amount of interest earned.
• P stands for principal, which is the amount you deposited, without interest.
• r stands for the annual rate of interest, which should be converted to a decimal — 3% = 0.03, for example.
• n is the number of times the interest is compounded per year.
• t stands for time and is the number of years the principal remains in the account.

Practical Example

Here’s what that looks like in practice:

Say you have $1,000 in an account that earns 6% — an outstanding rate, if you can find it — compounded yearly. To find out how much your savings will be worth in two years, plug in the numbers to the formula.

• A = P (1 + r/n)^(nt)
• A = 1000 (1 + 0.06/1)^(1)(2)
• A = 1000 (1 + 0.06)^(2)
• A = 1,123.60

The Rule of 72: Another Way To Understand What Compound Interest Is and How To Calculate It

To get a rough estimate rather than use a precise formula, follow the “Rule of 72.” Divide 72 by the expected interest rate to determine the number of years it will take to roughly double your money.

For example, earn 10% per year, and you will double your money in about 7.2 years, rather than the 10 years you would expect using simple interest — 10 years times 10% interest per year equals 100% earnings, or double.

What Are the Benefits of Compound Interest?

When you’re saving money, there are plenty of benefits to compound interest:

• Compound interest helps you earn more money in interest over time.
• Compound interest earns money quicker than simple interest.
• You don’t have to put away as much money to get to the same goal when you earn compound interest.

What Is Annual Percentage Yield?

APY is the total amount of interest earned on a deposit account per year. APY calculations include compounded interest. APY is often tied to savings and money market accounts or certificates of deposit. You can find details about the APY that applies to an account in a financial institution’s advertisement or in the Truth-in-Lending Disclosure from the bank or lender.

What Types of Accounts Offer Compound Interest?

Compound interest is a powerful tool when you’re saving and investing money in any of these accounts:

• Savings account: An account at banks and credit unions where you deposit money you want to save
• Money market: A savings account with features similar to a checking account, such as check-writing privileges
• Certificate of Deposit: A type of savings account in which you keep money for a pre-determined period of time
• Savings bond: A type of Treasury security citizens can purchase to help the government raise money, which offers a guaranteed return

Interest on Retirement Accounts

Investment accounts like individual retirement accounts and 401(k)s don’t earn compound interest, per se, unless the money is invested in interest-bearing securities. However, growth in any of these accounts has the same effect as long as your investments produce a positive return and you reinvest the earnings.

What Compound Interest Means to You: Taking Advantage of Compound Interest

When you understand how compound interest works, you can use it to your advantage.

Save Early

The sooner you start saving, the more time you have to let compound interest work. Here’s what can happen if you put $10,000 in an account that earns 3% interest that compounds monthly:

• 20 years: $18,207.55
• 30 years: $24,568.42
• 40 years: $33,151.49

Check the APY

Compare accounts. The higher the APY, the more money you stand to earn over time.

Check the APY offered by different banks. Also, check the APY offered on different products at the same bank, because rates can vary. Here is the range of APY currently available on CDs through Capital One:

• 6 months: APY
• 12 months: APY
• 24 months: APY
• 60-month: APY

Here’s how rates for a 12-month CD compare at four different banks:

• Ally Bank: APY
• Bank of America, Member FDIC: APY
• Capital One: APY
• Citi®: APY

Know the Compounding Frequency

Interest can compound daily, monthly, semi-annually or annually. For example, if an account earns compound interest annually, the interest is deposited into the account once per year. How often interest compounds can make a dramatic difference in your account balance. Here’s a look at how frequency affects your earnings:

• $1,000 at 3% compounded daily for 20 years: $1,822.07
• $1,000 at 3% compounded monthly for 20 years: $1,820.75
• $1,000 at 3% compounded semi-annually for 20 years: $1,814.02
• $1,000 at 3% compounded annually for 20 years: $1,806.11

When Can Compound Interest Work Against You?

The same principal of compound interest that applies to savings and investments also applies to the interest lenders charge on money you borrow. When you owe money on a loan or credit card, compound interest works against you. The sooner you pay back the money you borrow, the less it will cost you.

Say, for example, you borrow $10,000 at 6% interest that compounds daily. If you pay off the loan in five years, you pay $1,603.74 in interest. If you pay off the loan in three years, you pay $954.27 in interest. That’s a difference of more than $600 that you could have saved just by paying off your debt more quickly.

Ashley Eneriz and Daria Uhlig contributed to the reporting for this article.

Rates are subject to change; unless otherwise noted, rates are updated periodically. All other information on accounts is accurate as of March 16, 2023.

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