Compound interest is the mechanism behind most long-term wealth building — and, on the flip side, behind runaway credit card debt. The core idea is simple: instead of earning a fixed dollar amount every year, you earn a percentage of a balance that keeps growing, so the dollar amount you earn also keeps growing.
The Formula
Worked Example
Say you invest $10,000 at a 7% annual rate, compounded annually, for 20 years: A = 10,000 × (1 + 0.07)20 = $38,697. Compare that to simple interest on the same terms: 10,000 + (10,000 × 0.07 × 20) = $24,000. Compounding earned you nearly $15,000 more purely from the "interest on interest" effect.
| Year | Simple Interest | Compound Interest |
|---|---|---|
| 5 | $13,500 | $14,026 |
| 10 | $17,000 | $19,672 |
| 20 | $24,000 | $38,697 |
| 30 | $31,000 | $76,123 |
Notice how the gap between the two lines widens dramatically after year 10 — that's compounding's signature exponential curve kicking in.
Why Compounding Frequency Matters (a Little)
The same $10,000 at 7% for 20 years compounded quarterly instead of annually yields $39,616 rather than $38,697 — a modest $919 improvement. Daily compounding pushes it to $40,163. Frequency helps, but it's a minor lever compared to time and rate, which drive the vast majority of the outcome.
Figures above are illustrative estimates only, not financial advice. Actual investment returns are not guaranteed and can vary.