What compound interest is and how it works

Compound interest definition

Compound interest is growth calculated on both the original balance and the returns already added to it. The calculation base therefore changes over time.

If $10,000 grows by 5% a year, it becomes $10,500 after one year. In year two, the 5% applies to $10,500 rather than only the original $10,000.

How cumulative growth develops

Initial capital, return, time and contributions determine the result. Time magnifies differences, but it does not guarantee a profit because real returns vary.

Recurring contributions

Regular deposits add new capital. A deposit made at the beginning of a period has slightly longer to grow than one made at the end.

Compounding frequency

Frequency matters for a nominal rate. An effective annual rate already expresses the complete annual outcome.

Inflation, fees and real value

Inflation reduces future purchasing power. Fees reduce the balance available to compound; even small annual costs can produce a large long-term difference.

Benefits and limitations

Compounding is a mathematical mechanism, not an investment product. A constant-rate projection is useful for comparing assumptions, but it is not a market forecast and excludes taxes.

Common questions

Compound growth can also be negative when the return is negative. More frequent compounding produces a higher effective return only when the nominal rate is held constant.

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