What is compound interest and how does it work?

Knowing how compound interest works could help you make smarter choices about saving, borrowing and paying down debt. Once you understand how interest builds over time, you can compare your options and decide what best fits your financial goals.

What is compound interest? 

Compound interest is interest that builds on both the original amount in your account — also called the principal — and any interest you’ve already earned. That’s why compound interest is sometimes described as “interest on interest.”

Compound interest may help your savings grow faster than simple interest, especially when you leave money in the account over time. You may see compound interest with savings accounts, certificates of deposit and investment accounts where earnings are reinvested.

What's the difference between simple interest and compound interest? 

Simple interest means only the principal earns interest. While your money still grows, it earns the same amount of interest each period.

That doesn’t mean simple interest is bad. In fact, paying simple interest on a loan may cost less than compound interest. However, the total cost of borrowing depends on other factors, such as interest rate, loan term and fees.

How does compound interest work?

Say you have $1,000 in a savings account that earns 2% interest, compounded annually. If you do nothing with the account for the first year, you’ll earn $20 in interest, giving you $1,020.

In the second year, however, you could earn $20.40 in interest, assuming you don’t deposit or withdraw any funds. Your account balance would then be $1,040.40, because your bank calculated the interest payment on the $1,020 in your account from the first year.

If your savings account earned simple interest, you’d earn $20 every year. Instead of having $1,040.40 at the end of two years, you'd have $1,040.

The difference might not seem like much, but compounding interest typically works like a snowball. The interest you earn in one year increases the amount used to calculate interest in the next. By the fifth year, assuming you make no deposits or withdrawals, you could have $1,104.08 in your account.¹

Common questions about compound interest

Why is compound interest called the key to building wealth?

When you leave money in an interest-earning account, each interest payment increases the balance used to calculate future interest. The longer your money stays in the account, the more time compound interest has to build — especially if you continue adding to your savings.

At what point does compound interest take off?

Compound interest starts working as soon as interest is added to your balance. However, the growth often becomes more noticeable over time because each new interest payment increases the amount used to calculate future interest.

What is the downside to compound interest?

One downside to compound interest is that it could increase debt the same way it helps savings grow. When interest compounds on a balance you owe, you pay interest on both the original amount borrowed and unpaid interest. Credit card interest, for example, may compound daily if you carry a balance, which could make repayment more difficult over time.

Use compound interest to guide your next money move

Compound interest can help your savings grow over time. Once you know how to calculate compound interest, you can better compare accounts, understand borrowing costs and make choices that support your financial goals.

Want to become savvier with savings beyond understanding how compound interest works? Make an appointment today to open a U.S. Bank savings account.