What it is
Compound interest works by adding earned interest back to the principal sum, causing the next interest calculation to be based on a larger amount. This process allows an investment or debt to grow at an accelerating rate over time, as interest effectively earns interest itself. It contrasts with simple interest, which is calculated only on the original principal amount. The frequency of compounding, such as daily, monthly, or annually, impacts the overall growth.
For investors, compound interest is a powerful mechanism for wealth accumulation, particularly in long-term savings accounts, retirement funds, and dividend reinvestment plans. When companies pay dividends, reinvesting them allows those dividends to generate future dividends, illustrating compounding. For borrowers, it means debt, like credit card balances or loans, can grow rapidly if not paid down, as interest accrues on both the original principal and any unpaid interest.
Why it matters
Understanding compound interest is crucial for long-term financial planning, as it demonstrates how investments can grow exponentially and how debt can accumulate.
Reviewed under editorial standardsUpdated September 26, 2026Not investment advice