How Compound Interest Works
Interest on interest, why time beats rate, and why the same math magnifies debt.
4 min read
Step by step
- Future value = P × (1 + r/n)^(nt).
- Each period's interest joins the balance and earns interest itself.
- Example: $10,000 at 6% compounded monthly becomes $18,194 in 10 years.
- Compare products by APY, which includes compounding.
Key takeaway: Starting earlier matters more than finding a higher rate.
Interest on interest
Compounding means each period's interest is added to the balance, so the next period earns interest on a larger amount. The future value formula is P × (1 + r/n)^(nt), where r is the annual rate, n the compounding periods per year, and t the years.
$10,000 at 6% compounded monthly for 10 years grows to $18,194 — the compounding added $8,194, about 37% more than the $6,000 simple interest would have paid.
Time beats rate
The exponent in the formula is time, which is why starting early matters more than finding a slightly better rate. $200 per month at 7% from age 25 grows to about $525,000 by 65; starting at 35 yields roughly $244,000 — less than half, for only ten fewer years of contributions.
This is the single most important idea in personal finance: the last years of growth are the biggest, and you only get them by starting sooner.
Compounding works against borrowers too
Credit cards compound daily at high rates, which is why minimum payments barely move a balance. The same math that builds savings magnifies debt.
Compare products using APY (annual percentage yield), which includes compounding, rather than the nominal rate, which does not.
Do it automatically
Future value of savings or investments with recurring contributions.
Open the Compound Interest Calculator