Compound interest means you earn interest on the money you saved and also on the interest you have already earned. It is interest on interest.
A $1,000 example, year by year
The CFPB, the US consumer finance regulator, uses a simple case. You start with $1,000. That starting amount is your principal. It earns 5 percent a year, and the interest is added once a year.
After the first year, you have $1,050. The interest is 0.05 times $1,000, or $50.
After the second year, the interest is 0.05 times $1,050, or $52.50. Your balance is $1,102.50.
Where the extra $2.50 comes from
Look at the two years side by side. The first year earned $50. The second earned $52.50. The extra $2.50 is interest earned on the first year’s interest.
If interest were paid only on the original $1,000, you would earn $50 a year. After two years you would have $1,100. That is our own arithmetic, not a figure from the CFPB. The gap is small after two years, and it grows as the years pass.
Three words to know
The CFPB gives other names for the parts of the example. The amount you start with is your principal. How much you earn is your interest rate, also called the rate of return. How often interest is calculated is your compounding frequency.
What makes savings grow faster
The CFPB lists three things that help savings grow faster. You can increase how often interest is compounded. You can find a higher interest rate. And you can add to your principal.
You can try different rates, time periods and compounding frequencies on the Securities and Exchange Commission’s website, Investor.gov. The CFPB page was last reviewed in October 2023. This post explains how the sum works. It is not advice on where to put your money.
