Compound interest is the addition of interest earned on an amount of money back into the principal. Each addition of interest increases the principal amount. Thus, the interest earned (not the interest rate) increases with the increase in prinicpal.
Compound interest can be contrasted with simple interest where the latter is not added back into the principal.
Following is an example of compound interest savings with a $1,000 initial principal and a 10% interest rate:
Year |
Amount |
Interest Earned (10% of Amount) |
Amount + Interest Earned |
1 |
$1,000 |
$100 |
$1,100 |
2 |
$1,100 |
$110 |
$1,210 |
3 |
$1,210 |
$121 |
$1,331 |
4 |
$1,331 |
$133 |
$1,464 |
5 |
$1,464 |
$146 |
$1,610 |
The example demonstrates the power of compound interest. With a $1,000 initial amount, it will grow to $1,621 in 5 years with a 10% interest rate. Of course actual checking and savings rates are much lower, but the principle of this effect demonstrates the importance of maximizing interest rates for savings and minimizing for loans. See our Calculators page to determine actual scenarios.