How Does Compound Interest Work?


You’d think that to accumulate a lot of money, whether in a savings account, retirement savings plan, or brokerage account, you’d need to consistently put a lot of money away. But if you save and invest your money wisely over a long period, you could wind up pleasantly surprised at the level of wealth you achieve.

If the idea of watching your money grow before your eyes sounds appealing, it pays to take advantage of the power of compound interest and returns.

Here we’ll review what compounded growth entails and show you how a series of relatively modest contributions to a savings or investment account can evolve into a substantial sum over time.

How does compound interest work?

At its core, compounding is the concept of earning interest on interest.

Imagine you put an initial deposit of $1,000 into a savings account that pays 2% interest. That means after a year, your balance will grow to $1,020 without adding any more money.

Now here’s the cool part: If you keep that money where it is, you’ll continue earning interest on not just the initial $1,000 you put in, but also on that $20. Assuming your interest rate stays the same, you’ll earn $20.40 in interest in your second year of having that money in that account, for a balance of $1,040.40.

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After 40 years in that account, earning the same interest, your $1,000 will grow to $2,208.04 — more than double your initial savings, with no extra investment or work.

Generally, you don’t just sock away a lump sum of money and come back to it in 40 years. In reality, most people save or invest some each week or month. So your savings grows with your principal — the money you put in — plus the interest that continues to compound as the initial balance grows with both principal and interest.

What are the benefits of compound interest?

The upside of compounding? It can grow your money. Interest means you earn money without needing to do any extra work. Then, the money you earned continues earning even more — that’s compounding. Your money continues to grow, whether you continue to add to it or not.

The downside: If you’re being charged compound interest — say, for a credit card balance — your debt can grow just as easily.

How does compound interest work in the stock market?

Imagine you’re looking to invest your money for a long-term goal, like retirement, and you put $100 a month into a brokerage account or IRA instead of a bank account. A high-yield savings account might pay just 2% interest.

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By contrast, investing in the stock market has historically delivered a 10% average yearly return — though a return in any given year fluctuates quite a bit. To be conservative, we’ll use a 7% return for our calculations.

The following table shows how much money you could wind up with, depending on how many years you continue to save:

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