Compound Interest

Interest is added to your balance at regular intervals, and the next round of interest is calculated on that new, larger balance. Simple interest, by contrast, only ever pays on the original amount.

Suppose you save 100 at 10% a year. In the first year you earn 10 and have 110. In the second year you earn 11 and have 121. In the third year you earn 12.10 and have 133.10. The rate stays at 10%, but the interest you earn grows every year because each year starts from a bigger balance.

Compounding works faster with a higher interest rate, with more frequent compounding, such as monthly instead of yearly, and, most of all, with more time. The effect looks small in the first few years but becomes the main source of growth over decades.

Compounding also works against borrowers. When interest on a loan or credit card is not paid off, it is added to the debt, and you are then charged interest on that interest too.