What is compound interest?

For savers, the definition of compound interest is basic: It’s the interest you earn on both your original money and on the interest you keep accumulating. Compound interest allows your savings to grow faster over time.

In an account that pays compound interest, such as a standard savings account, the return gets added to the original principal at the end of every compounding period, typically daily or monthly. Each time interest is calculated and added to the account, it results in a larger balance. With the compound interest formula, the account earns more interest in the next compounding period.

For example, if you put $10,000 into a savings account with a 4% annual yield, compounded daily, you’d earn $408 in interest the first year, $425 the second year, an extra $442 the third year and so on. After 10 years of compounding, you would have earned a total of $4,918 in interest.

But remember, that’s just an example. For longer-term savings, there are better places than savings accounts to store your money, including Roth or traditional IRAs and CDs.

Compounding investment returns

When you invest in the stock market, you don’t earn a set interest rate but rather a return based on the change in the value of your investment. When the value of your investment goes up, you earn a return.

If you leave your money and the returns you earn are invested in the market, those returns compound over time in the same way that interest is compounded.

If you invested $10,000 in a mutual fund and the fund earned a 6% return for the year, it means you gained $600, and your investment would be worth $10,600. If you got an average 6% return the following year, it means your investment would be worth $11,236.

Over the years, that money can really add up: If you kept that money in a retirement account over 30 years and earned that average 6% return, for example, your $10,000 would grow to more than $57,000.

In reality, investment returns will vary year to year and even day to day. In the short term, riskier investments such as stocks or stock mutual funds may actually lose value. But over a long time horizon, history shows that a diversified growth portfolio can return an average of 6% annually. Investment returns are typically shown at an annual rate of return.

Compounding can help fulfill your long-term savings and investment goals, especially if you have time to let it work its magic over years or decades. You can earn far more than what you started with.

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Compounding with additional contributions

As impressive as compound interest might be, progress on savings goals also depends on making steady contributions.

Let’s go back to the savings account example above and use the daily compound interest calculator to see the impact of regular contributions. We started with $10,000 and ended up with $4,918 in interest after 10 years in an account with a 4% annual yield. But by depositing an additional $100 each month into your savings account, you’d end up with $29,648 after 10 years, when compounded daily. The interest would be $7,648 on total deposits of $22,000.