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How does compound interest work?
Quick answer
Compound interest works by paying interest on both your original money and the interest it has already earned. Each period the balance grows a little more, and that larger balance earns even more next time — accelerating growth. Period one: you earn interest on your initial deposit (the principal).
Step by step
- Period one: you earn interest on your initial deposit (the principal).
- Period two onward: you earn interest on the principal plus all prior interest.
- More frequent compounding (monthly vs yearly) grows the balance faster.
- Time is the biggest factor — the longer it runs, the more dramatic the snowball.
People also ask
How is it different from simple interest?
Simple interest is paid only on the principal; compound interest is paid on the principal plus all accumulated interest.
What is the Rule of 72?
Divide 72 by the annual interest rate to estimate how many years it takes your money to double.
Does compounding frequency matter?
Yes — the more often interest is added, the sooner you earn interest on interest, slightly boosting returns.
Part of the guide: Money Basics: Save, Borrow & Invest →