How Compound Interest Works: The Complete Guide

What Is Compound Interest?

Compound interest is interest calculated on both your initial deposit AND the interest you've already earned. It's "interest on interest"—and it's the reason patient savers build wealth.

With simple interest, you only earn on your original deposit. With compound interest, each interest payment becomes part of your balance, and future interest is calculated on that larger amount.

A Simple Example

Let's say you deposit $10,000 in a savings account earning 4% APY, compounded annually:

Notice how the annual interest grows each year—from $400 in Year 1 to increasingly larger amounts. By Year 30, you've more than tripled your money, with $22,433.98 coming purely from interest.

The Compound Interest Formula

For the math-curious, here's the formula:

Don't worry about memorizing this—banks calculate it for you. The key insight is that more frequent compounding (higher "n") means slightly more money.

Daily vs Monthly vs Annual Compounding

Most high-yield savings accounts compound daily. Here's how compounding frequency affects your returns on $10,000 at 4%:

The difference between annual and daily compounding is about $850 over 30 years on $10,000. Noticeable, but not life-changing. The bigger factors are your interest rate and how long you leave money to grow.

The Rule of 72: A Handy Shortcut

The Rule of 72 tells you how long it takes to double your money at any interest rate:

Examples:

• At 4% APY: 72 ÷ 4 = 18 years to double
• At 6% APY: 72 ÷ 6 = 12 years to double
• At 0.01% APY: 72 ÷ 0.01 = 7,200 years to double (ouch)

This is why savings account rates matter so much. At 4%, your money doubles in 18 years. At a traditional bank's 0.01%, it takes 7,200 years—longer than recorded human history.

The Three Factors That Maximize Compound Interest

1. Time: Start Early

Time is the most powerful factor. Money invested early has decades to compound, while money invested late has years.

2. Rate: Every Percent Matters

Small rate differences compound into large dollar differences over time.

$10,000 over 30 years:

• 0.01% APY: $10,030 (traditional bank)
• 3.00% APY: $24,273
• 4.00% APY: $32,434
• 5.00% APY: $43,219

The difference between 3% and 5% is almost $19,000—on just $10,000 invested.

3. Consistency: Add Regularly

Regular contributions amplify compounding. Each deposit starts its own compounding journey.

$200/month at 4% APY:

• After 10 years: $29,388 (deposited $24,000)
• After 20 years: $73,310 (deposited $48,000)
• After 30 years: $139,636 (deposited $72,000)

After 30 years, you've nearly doubled your money through compounding alone—$67,636 in pure interest.

Compound Interest Works Against You Too

The same force that grows savings can devastate debt. Credit cards compound interest against you:

• $10,000 credit card debt at 24% APR: If you only pay minimums, you could pay $25,000+ in interest before it's gone
• Student loans at 7%: The balance grows even while you're in school
• Mortgage interest: Early payments are mostly interest, not principal

Lesson: Compound interest is a tool. Make it work for you (savings) rather than against you (debt).

Compound Interest vs Inflation

One important caveat: inflation erodes purchasing power. If you earn 4% but inflation is 3%, your "real" return is only 1%.

This is why even high-yield savings accounts aren't optimal for long-term wealth building—investments typically outpace inflation better. But for emergency funds, short-term goals, and stability, compound interest in savings accounts is still valuable.

The Bottom Line

Compound interest is the most reliable wealth-building tool available to ordinary savers. The formula is simple:

1. Start early: Time is the biggest factor
2. Find the best rate: Every percent matters
3. Add regularly: Each deposit compounds separately
4. Be patient: The magic happens in later years

Traditional banks paying 0.01% are robbing you of compound interest's power. High-yield accounts paying 4%+ let compounding work as intended.

Your future self will thank you for understanding this one concept.