What is compound interest?
By definition, compound interest is interest paid on any principal and interest paid thereafter.
...What?Basically, you put money into a savings account, money market account, CD, etc. - this is your principal. Your principal then earns interest. With compound interest, the interest you've already earned also earns more interest!
How does compound interest work?
Here's a simple example: You deposit $1,000 into a money market account, and this money market account pays 5% interest.
- After 1 year, you have earned 5% of $1,000 in interest - or $50.
Starting the next year, your principal (or starting balance) is now $1,050.
- In the next year, you will earn 5% of $1,050 - or $52.50.
The example above uses annual compounding. In other words, once per year, the interest accrued so far is added back to the principal and begins earning interest itself.
It may not seem like much of a big deal from the example above - that was only an extra $2.50. However, the effect really starts to snowball, and the value of your investment can begin to increase exponentially over time.