Compound Interest

When your money earns money on the money it already earned

Understanding how reinvesting earnings creates exponential wealth growth over time
Modified

September 7, 2025

Category: General Finance
Difficulty: Beginner

Definition

When your investment earnings get reinvested to earn even more money. Your money grows faster because you’re earning returns on both your original investment AND on all the money it has earned over time.

How It Works

Simple Example

You invest $1,000 at 10% per year:

  • Year 1: $1,000 → $1,100 (earned $100)
  • Year 2: $1,100 → $1,210 (earned $110, not just $100!)
  • Year 3: $1,210 → $1,331 (earned $121)

Each year you earn money on a bigger amount.

The Power of Time

$1,000 invested at 7% annual return: - After 10 years: $1,967 - After 20 years: $3,870 - After 30 years: $7,612 - After 40 years: $14,974

The longer you wait, the faster it grows.

Key Factors

Time is Everything

  • Start early: The most important factor
  • Stay invested: Don’t withdraw money
  • Be patient: The big growth happens later

Example: Start at age 25 vs. age 35 - Start at 25, invest $200/month until 65: $525,000 - Start at 35, invest $200/month until 65: $245,000 - Starting 10 years earlier more than doubles your money!

Higher Returns Matter

Small differences in returns create huge differences over time:

$10,000 invested for 30 years: - 5% return: $43,219 - 7% return: $76,123 - 9% return: $132,677

Frequency of Compounding

How often your money compounds affects growth:

  • Annually: Once per year
  • Monthly: 12 times per year
  • Daily: 365 times per year

More frequent compounding = slightly more growth.

Real-World Applications

Retirement Savings

  • 401(k): Money grows tax-free until retirement
  • IRA: Same tax advantage as 401(k)
  • Start young: Time is your biggest advantage

The Downside: Debt

Compound interest works against you with debt:

  • Credit cards: 20%+ interest compounding monthly
  • Pay off high-interest debt first: It grows just as fast as investments

Investment Accounts

  • Reinvest dividends: Buy more shares automatically
  • Don’t withdraw: Let it keep growing
  • Regular contributions: Add money consistently

Simple Rules

Getting Started

  • Start as early as possible
  • Invest regularly (even small amounts)
  • Choose low-fee investments
  • Don’t touch the money

Common Mistakes

  • Waiting to start investing
  • Taking money out early
  • Trying to time the market
  • Paying high fees

The “Rule of 72”

Quick way to estimate how long money takes to double: 72 ÷ interest rate = years to double

  • At 6%: 72 ÷ 6 = 12 years to double
  • At 9%: 72 ÷ 9 = 8 years to double

External Resources