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Table of Contents
What Is Compound Interest?
How Compound Interest Works
The Power of Compound Interest
Compound Interest: Start Saving Early
Pros and Cons Compound Interest
Compound Interest in Investing
Calculating Compound Interest
Online Calculators for Compound Interest
Compound Interest FAQs
The Bottom Line
PERSONAL FINANCE BANKING
The Power of Compound Interest: Calculations and Examples
Discover the magic of compounding and why it's important to increasing wealth

By JASON FERNANDO Updated February 28, 2024

Reviewed by ROBERT C. KELLY
Fact checked by TIMOTHY LI
What Is Compound Interest?
Compound interest is interest that applies not only to the initial principal of an
investment or a loan, but also to the accumulated interest from previous periods.
In other words, compound interest involves earning, or owing, interest on your
interest.

The power of compounding helps a sum of money grow faster than if just simple
interest were calculated on the principal alone. And the greater the number of
compounding periods, the greater the compound interest growth will be. For savings
and investments, compound interest is your friend, as it multiplies your money at
an accelerated rate. But if you have debt, compounding of the interest you owe can
make it increasingly difficult to pay off.

KEY TAKEAWAYS
Compounding multiplies savings or debt at an accelerated rate.
Compound interest is interest calculated on both the initial principal and all of
the previously accumulated interest.
Generating "interest on interest" is known as the power of compound interest.
Interest can be compounded on a variety of frequencies, such as daily, monthly,
quarterly, or annually.
The higher the number of compounding periods, the larger the effect of compounding.
Compound Interest
Investopedia / Julie Bang

How Compound Interest Works

Compound interest is calculated by multiplying the initial principal amount by one
plus the annual interest rate raised to the number of compound periods minus one.
The total initial principal or amount of the loan is then subtracted from the
resulting value.

What is Compound Interest?

Katie Kerpel {Copyright} Investopedia, 2019.
The formula for calculating compound interest is:

Compound interest = total amount of principal and interest in future (or future
value) minus principal amount at present (or present value)
= [P (1 + i)n] – P
= P [(1 + i)n – 1]
Where:

P = principal
i = annual interest rate
n = number of compounding periods
As an example, take a 3-year loan of $10,000 at an interest rate of 5%, compounding
annually. What would be the amount of interest? In this case, it would be:

$10,000 [(1 + 0.05)3 – 1] = $10,000 [1.157625 – 1] = $1,576.25

The Rule of 72 is another way to estimate compound interest. If you divide 72 by
your rate of return, you find out how long it will take your money will double in
value. For example, if you have $100 that was earning a 4% return, it would grow to
$200 in 18 years (72 / 4 = 18).
1
The Power of Compound Interest
Because compound interest includes interest accumulated in previous periods, it
grows at an ever-accelerating rate. In the example above, though the total interest
payable over the loan's three years is $1,576.25, the interest amount is not the
same as it would be with simple interest. The interest payable at the end of each
year is shown in the table below.

Compound interest can significantly boost investment returns over the long term.
Over 10 years, a $100,000 deposit receiving 5% simple annual interest would earn
$50,000 in total interest. But if the same deposit had a monthly compound interest
rate of 5%, interest would add up to about $64,700. While compound interest is
interest-on-interest, cumulative interest is the addition of all interest payments.

Order your copy of Investopedia's What To Do With $10,000 magazine for more wealth-
building advice.
Compounding Interest Periods
Compounding periods are the time intervals between when interest is added to the
account. Interest can be compounded annually, semi-annually, quarterly, monthly,
daily, continuously, or on any other basis.
2

Interest on an account may accrue daily but only credited monthly. Only when the
interest is credited, or added to the existing balance, does the interest begin to
earn additional interest. Standard compounding frequency schedules are usually
applied to financial instruments:

Savings accounts and money market accounts: The commonly used compounding schedule
for savings accounts at banks is daily.
Certificate of deposit (CD): Typical CD compounding frequency schedules are daily
or monthly.
Series I bonds: Interest is compounded semiannually, or every six months.
3
Loans: For many loans, interest is often compounded monthly. However, compounding
interest may be called something different, such as "interest capitalization" for
student loans.
4
Credit cards: Card interest is often compounded daily, which can add up fast.
5

Some banks also offer continuously compounding interest, which adds interest to the
principal as regularly as possible. For practical purposes, it doesn’t accrue that
much more than daily compounding interest unless you want to put money in and take
it out on the same day.

Compounding Period Frequency

More frequent compounding of interest is beneficial to the investor or creditor.
For a borrower, the opposite is true. The basic rule is that the higher the number
of compounding periods, the greater the amount of compound interest.
6

The following table demonstrates the difference that the number of compounding
periods can make for a $10,000 loan with an annual 10% interest rate over a 10-year
period.

Compound Interest: Start Saving Early

Young people often neglect to save for retirement. They may have other expenses
they feel more urgent with more time to save. Yet the earlier you start saving, the
more compounding interest can work in your favor, even with relatively small
amounts. Saving small amounts can pay off massively down the road—far more than
saving higher amounts later in life. Here's one example of its effect.

Let’s say you start saving $100 a month at age 20. You earn an average of 4%
annually, compounded monthly across 40 years. You earn $151,550 by age 65. Your
principal investment was just $54,100.

Your twin doesn’t begin investing until age 50. They invest $5,000 initially, then
$500 monthly for 15 years, also averaging a monthly compounded 4% return. By age
65, your twin has only earned $132,147, with a principal investment of $95,000.

When you hit your 45-year savings mark—and your twin would have saved for 15 years—
your twin will have less, although they would have invested roughly twice your
principal investment.

The same logic applies to opening an individual retirement account (IRA) and taking
advantage of an employer-sponsored retirement account, such as a 401(k) or 403(b)
plan. Start early and be consistent with your payments to get the maximum power of
compounding.
Pros and Cons Compound Interest
Pros
Can help build wealth long-term in savings and investments

Mitigates wealth erosion risks

Compounding can work for you when making loan repayments

Cons
Works against consumers making minimum payments on high-interest loans or credit
card debts

Returns are taxable

Challenging to calculate

Advantages Explained
Can help build wealth long-term in savings and investments: Compounding works to
your advantage when it comes to your investments and savings, as your returns earn
returns.
Mitigates wealth erosion risks: Compounding interest's exponential growth is also
important in mitigating wealth-eroding factors, such as increases in the cost of
living, or inflation that reduces purchasing power.
Compounding can work for you when making loan repayments: When you make more than
your minimum payment, you can leverage the power of compounding to save on total
interest.
Disadvantages Explained
Works against consumers making minimum payments on high-interest loans or credit
card debts: If you only pay the minimum, your balance could continue growing
exponentially as a result of compounding interest. This is how people get trapped
in a "debt cycle."
Returns are taxable: Earnings from compound interest are taxable at your tax
bracket unless the money is in a tax-sheltered account.
7
8
Challenging to calculate: Calculating simple interest is fairly easy, but
calculating compounding interest requires more math. It may be easiest to use an
online calculator.
Compound Interest in Investing
An investor opting for a brokerage account's dividend reinvestment plan (DRIP) is
essentially using the power of compounding in their investments.

Assets that have dividends, like dividend stocks or mutual funds, offer a one way
for investors to take advantage of compound interest. Reinvested dividends are used
to purchase more shares of the asset. Then, more interest can grow on a larger
investment.
Investors can also get compounding interest with the purchase of a zero-coupon
bond. Traditional bond issues provide investors with periodic interest payments
based on the original terms of the bond issue. Because these payments are paid out
in check form, the interest does not compound.

Zero-coupon bonds do not send interest checks to investors. Instead, this type of
bond is purchased at a discount to its original value and grows over time. Zero-
coupon-bond issuers use the power of compounding to increase the value of the bond
so it reaches its full price at maturity.
9

Tools for Calculating Compound Interest

You can use several tools to help you calculate compound interest, including
Microsoft Excel, which you can use in three different ways:

Approach One: Multiplication

The first way to calculate compound interest is to multiply each year’s new balance
by the interest rate.

Suppose you deposit $1,000 into a savings account with a 5% interest rate that
compounds annually, and you want to calculate the balance in five years.

In Microsoft Excel, enter “Year” into cell A1 and “Balance” into cell B1.
Enter years 0 to 5 into cells A2 through A7.
The balance for year 0 is $1,000, so you would enter “1000” into cell B2.
Next, enter “=B2*1.05” into cell B3.
Then enter “=B3*1.05” into cell B4 and continue to do this until you get to cell
B7.
In cell B7, the calculation is “=B6*1.05”.
Finally, the calculated value in cell B7—$1,276.28—is the balance in your savings
account after five years.
To find the compound interest value, subtract $1,000 from $1,276.28; this gives you
a value of $276.28.
Approach Two: Fixed Formula
The second way to calculate compound interest is to use a fixed formula.

The compound interest formula is ((P*(1+i)^n) - P), where P is the principal, i is

the annual interest rate, and n is the number of periods.

Using the same financial information as in Approach One, enter “Principal value”
into cell A1 and “1000” into cell B1.
Next, enter “Interest rate” into cell A2 and “.05” into cell B2.
Enter “Compound periods” into cell A3 and “5” into cell B3.
Now you can calculate the compound interest in cell B4 by entering
“=(B1*(1+B2)^B3)-B1”, which gives you $276.28.
Approach Three: Macro Function
A third way to calculate compound interest is to create a macro function.

First start the Visual Basic Editor, which is located in the developer tab.
Click the Insert menu, and click on “Module.”
Then type “Function Compound_Interest (P As Double, I As Double, N As Double) As
Double” in the first line.
On the second line, hit the tab key and type in “Compound_Interest = (P*(1+i)^n) -
P.”
On the third line of the module, enter “End Function.”
You have created a function macro to calculate the compound interest rate.
Continuing from the same Excel worksheet above, enter “Compound interest” into cell
A6 and enter “=Compound_Interest(B1, B2, B3).” This gives you a value of $276.28,
which is consistent with the first two values.
Online Calculators for Compound Interest
You can also use several free compound interest calculators online.
Investor.gov Compound Interest Calculator: This U.S. Securities and Exchange
Commission (SEC), site offers a free online compound interest calculator. It is
fairly simple and also allows inputs of monthly additional deposits to the
principal, which helps calculate earnings when additional monthly savings are being
deposited.
10
TheCalculatorSite.com Compound Interest Calculator: This calculator allows
calculations for five different currencies, factoring in monthly deposits or
withdrawals, and automatic calculation of inflation-adjusted increase options for
monthly deposits or withdrawals.
11
Council for Economic Education Compound Interest Calculator: This calculator is
geared toward students and demonstrates the long-term power of compounding. Enter
your age, annual interest rate, initial investment, and monthly savings. The
resulting graph shows your money growing over time and the difference between total
earnings and principal.
12
How Can I Tell if Interest Is Compounded?
The Truth in Lending Act (TILA) requires that lenders disclose loan terms to
potential borrowers, including the total dollar amount of interest to be repaid
over the life of the loan and whether interest accrues simply or is compounded.
13

What Is a Simple Definition of Compound Interest?

Compound interest simply means you're earning interest on both your original saved
money and any interest you earn on that original amount. Although the term
"compound interest" includes the word interest, the concept applies beyond
interest-bearing bank accounts and loans, including investments such as mutual
funds.
14

Who Benefits From Compound Interest?

Compound interest benefits investors across the spectrum. Banks benefit from
compound interest lending money and reinvesting interest received into additional
loans. Depositors benefit from compound interest receiving interest on their bank
accounts, bonds, or other investments.

The Bottom Line

The long-term effect of compound interest on savings and investments is indeed
powerful. Because it grows your money much faster than simple interest, compound
interest is a central factor in increasing wealth. It also mitigates a rising cost
of living caused by inflation.

For young people, compound interest offers a chance to take advantage of the time
value of money. Remember when choosing your investments that the number of
compounding periods is just as important as the interest rate.
ARTICLE SOURCES
Related Terms
Cumulative Interest Definition, Formulas and Uses
Cumulative interest is the sum of all interest payments made on a loan over a
certain time period. more
What Is APY and How Is It Calculated?
The annual percentage yield (APY) is the effective rate of return on an investment
for one year taking compounding interest into account. more
Principal: Definition in Loans, Bonds, Investments, and Transactions
Principal is money that's lent to a borrower or placed into an investment. It can
also refer to a private company’s owner or the chief participant in a deal. more
Annual Percentage Rate (APR): What It Means and How It Works
Annual Percentage Rate (APR) is the interest charged for borrowing that represents
the actual yearly cost of the loan, including fees, expressed as a percentage. more
Effective Annual Interest Rate: Definition, Formula, and Example
The effective annual interest rate is the return on an investment or the rate owed
in interest on a loan when compounding is taken into account. more
Interest Rates: Different Types and What They Mean to Borrowers
The interest rate is the amount lenders charge borrowers and is a percentage of the
principal. It is also the amount earned from deposit accounts. more
Related Articles
How Interest Works on Savings Accounts
How Interest Works on a Savings Account

Cumulative Interest Definition, Formulas and Uses

Girl with calculator and papers at desk
Simple Interest vs. Compound Interest: What's the Difference?
APR vs. APY
APR vs. APY: What’s the Difference?
Annual Percentage Yield (APY)
What Is APY and How Is It Calculated?
Financial advisor with laptop and paperwork meeting with woman in living room
How Do I Calculate Compound Interest Using Excel?
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