What Is Compound Interest and How Does It Work?

When you hear about the amount of money needed to retire, it can be pretty discouraging. How can anyone on a modest income save up $1,000,000 in their lifetime? 

The answer: compound interest.

Thanks to this magical math formula, the average person can absolutely save enough to retire — maybe even before “official” retirement age! 

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How Does Compound Interest Work?

Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn't pays it.”

He wasn’t exaggerating. If you want to save money, you have to understand how compound interest works and the factors that affect it. These include:

• Interest rate: The higher the interest rate, the more you’ll earn. However, higher-rate investments may carry more risk. 
• Principal balance: This is the amount you deposit when you open the account. For many people, that amount is $1.
• Frequency of compounding: Interest may be calculated daily, monthly, or annually. The more frequently interest compounds, the more interest you will earn.
• Duration: This is how long your funds are kept in a savings vehicle. The longer the funds earn interest, the more interest you will earn.

Even though it seems like interest rate or the size of the monthly contribution is the most important aspect of compound interest, time is actually the most important factor. 

That’s why most experts say you should start investing as soon as possible, no matter how much you can afford.

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With compound interest, as you accrue interest, that amount is added to the principal. Then, interest will accrue on the new principal. 

This is why money grows faster because of compound interest — because the interest also generates interest.

READ MORE: How to Start Investing When You Don’t Have Much Money

Where to earn compound interest

The following types of accounts offer compound interest:

• Checking and savings accounts: Some banks will compound your interest on checking and high-yield savings accounts (HYSAs). 
• CDs: A certificate of deposit (CD) is a savings vehicle offered by banks. CDs usually come with a contract that says how long you have to keep the money invested. The longer the contract, the higher the interest rate. 
• Investments: If you choose an investment that pays out dividends, you can reinvest those dividends and use the proceeds to purchase more shares. As the value of the shares increases, your total investment will also increase.

How compound interest works with debt 

Because compound interest is so powerful, it can also work against you when borrowing money. 

For example, if you have a credit card balance, you’ll be charged interest on that balance. If you don’t pay off the statement balance in full, then the new interest charges will be added to the principal. 

You’ll then be charged interest on the new balance. 

This is one of the main reasons why it’s so hard to pay off credit card debt — and why it’s so easy to rack up a balance that you can’t afford to pay off immediately. 

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How To Calculate Compound Interest

The equation for compound interest is:

A = P (1 + [r / n]) ^nt 

Here’s how it breaks down:

• A: The final future value of the balance
• P: The principal
• R: The rate of return or interest rate
• N: How often interest is compounded (i.e., 1 for annual compounding, 12 for monthly compounding, 365 for daily compounding, etc.)
• T: How long the funds are in the account

Let’s say you deposit $5,000 in an account earning 5% interest compounding monthly. 

You leave the money untouched for three years. The compounding equation would look like this: 

5,807.36  = 5,000 (1 + [0.05  / 12]) ^(12*3) 

That means you would have $5,807.36 after three years, having earned $807.36 in total interest.

If you don’t want to do the formula yourself, you can also use a compound interest calculator from the official U.S. Securities and Exchange Commission website. 

Play around with different amounts and time periods to see how much you can save.

Compound Interest vs. Simple Interest 

Not all savings accounts offer compound interest. Some only offer simple interest.

• Compound interest is when you earn money on both the principal and the interest. 
• Simple interest is when you only earn money on the principal. 

Here’s how that plays out with actual dollars. 

Let’s say you save $100 each month with 5% interest. If the interest is compounded daily, you’d earn $816.08 in interest over a five-year period. 

However, if you only earn simple interest at 5%, you’d have $300 in total interest after five years. That’s a difference of more than $500!

Always make sure that your savings accounts are earning compound interest and not simple interest.

Compound Interest Examples

The best part of compound interest is that it rewards those who start early, not necessarily those who invest the most.

Starting when you’re young

Let’s say you start investing at age 25 with only $100 a month. You invest in index funds, which return 7% annually on average. After 40 years, you have $239,562.

However, let’s say you wait a decade and start investing at 35 with $200 a month. 

Even though you have doubled your monthly contribution amount, you only have $226,705 at age 65 — that’s about $13,000 less than if you had started investing 10 years sooner!

Starting age	Monthly contribution	Return rate	Total saved at age 65
25	$100	7%	$239,562
35	$200	7%	$226,705

This is where the effects of procrastination really come into play. If you only begin investing at age 55 with a decade until retirement, you’d have to put $1,450 away each month just to get the same approximate nest egg as those who began at age 25.

READ MORE: Is It Too Late to Start Investing at 50?

Using a high-yield savings account vs. a regular savings account

Traditional savings accounts don't earn you much interest — around 0.45% APY (annual percentage yield) as of June 2024. So even though it's still compounding, it's not going to get you to your goal very quickly!

High-yield savings accounts, on the other hand, come with much higher interest rates — often as high as 5%.

For example, the SoFi Checking and Savings Account offers 4.30% APY compounded monthly and the CIT Bank Platinum Savings offers 4.70% APY and compounds daily.

Let's say you're setting up your emergency fund in a traditional savings account that offers you a 0.45% APY, compounded monthly. You deposit $100 every month for three years. At the end, you'd have $3,623.

Now, if you did the same thing with an HYSA that compounds daily at 5% APY, you'd end up with $3,883 That's an extra $260 thanks to compounding a higher interest rate more frequently.

Account type	Monthly deposit	APY	Compound frequency	Total after 3 years	Total after 10 years
Generic traditional account	$100	0.45%	Monthly	$3,623	$12,271
SoFi Checking and Savings Account	$100	4.30%	Monthly	$3,846	$15,119
CIT Bank Platinum Savings	$100	4.70%	Daily	$3,883	$15,567

That might not seem like a big difference, but remember that the real key to compound interest is time — that gap between a traditional savings account and an HYSA will keep getting bigger the longer you keep adding to it. In this case, there's a difference of over $3,000 after 10 years.

COMPARE: Best High-Yield Savings Accounts

Investing in the stock market vs. a savings account

While HYSAs are a great place to store money, they pay less interest than the average returns on the stock market. 

The best HYSAs typically max out around 5%, but the average historical return from the stock market has been about 7%.

For example, let's say you can put away $250 a month. You’re risk-averse so you decide to stash your money in a savings account instead of an individual retirement account (IRA). 

After 40 years at 3% annual interest, you have $226,203. Not too shabby, right?

But if you invested the money in an exchange-traded fund (ETF) through your IRA, earning 7% annual interest on average, you’d have $598,905 after 40 years. 

Account type	Monthly deposit	APY / Annual return rate	Total after 40 years
HYSA	$250	3%	$226,203
IRA	$250	7%	$598,905

That’s more than double what you would have earned in a savings account!

Plus, it doesn't have to cost you much to start investing — you don't need to start with $250. Apps like Webull let you invest in fractional shares and ETFs for as little as $5.

READ MORE: Should You Save or Invest Your Money? 

Saving for your kids

Most parents know that starting a college fund for their kids is one of the best things they can do. But investing that money can be even better. 

Instead of keeping your child’s college fund in a savings account, you can use a tax-advantaged account, like a 529. Plus, you can invest the money in a 529, just like you can with an IRA or 401(k).

For example, let’s say you save $100 a month from the day your child is born until they turn 18. If you choose a savings account with a 3% APY, you’d have $28,097. 

But after 18 years in the stock market at 7% annually, you would have $40,798 to spend on their college education.

Account type	Monthly deposit	APY / Annual return rate	Total after 18 years
HYSA	$100	3%	$28,097
529	$100	7%	$40,798

FAQs

What accounts are best for compounding interest?

Retirement investment accounts are the best for compound interest. Money grows faster in the stock market than in a bank account, and retirement accounts provide more tax-relief options than regular taxable brokerage accounts. 

If you need funds for a short-term reason or an account to keep your emergency fund, then you can use a regular savings account. This can still provide some benefits of compound interest, as long as you choose a high-yield savings account. 

Does interest compound monthly or annually?

It depends on the terms of the account. For example, some savings accounts may only compound once a month while others will compound daily.

It's always in your best interest to choose an account with the most frequent compounding schedule.

Is compound interest taxable?

What you earn through the power of compound interest is often taxable, but that depends on the type of account. 

For example, let’s say that you have a savings account with compounding interest. That interest will be reported on a 1099-INT form, which must be declared as income on your taxes.

If you invest money in a retirement account, such as Roth and traditional IRAs, 401(k)s, 457(b)s and 403(b)s, there are some tax benefits that don’t apply to other types of accounts. You may have to pay income tax at some point on these plans, but the compound interest usually grows tax-deferred.

If you earn money through compound interest in a Health Savings Account (HSA), you do not have to pay taxes as long as you spend the earnings on a qualified medical expense. If you use the funds for another purpose, you will have to pay taxes on the earnings.

TL;DR: Why Compound Interest is Important

Compound interest is the only reason that ordinary investors can save enough for retirement. Without the power of compound interest, it would be almost impossible to amass the funds you’ll need to survive decades of retirement. 

Compound interest turns pennies into dimes, dimes into dollars, and dollars into tens of thousands of dollars.

For more tips on saving and investing, check out these episodes of the Erika Taught Me podcast:

• How To Invest for Beginners (Step by Step)
• The 7 Baby Steps You NEED To Get to Financial Freedom
• The Missing Piece in 99% of Financial Advice

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