How Compound Interest Works
Compound interest is the process of earning interest on both your original investment and all the interest you've already accumulated. It's often called the "eighth wonder of the world" because small, consistent returns compound into outsized wealth over time — but only if you give them enough of it.
The Compound Interest Formula
- A
- Final amount (what you end up with)
- P
- Principal — your initial investment
- r
- Annual interest rate as a decimal (7% → 0.07)
- n
- Compounding periods per year (12 = monthly)
- t
- Time in years
Example: $10,000 at 7% compounded monthly for 20 years → 10,000 × (1 + 0.07/12)240 = $40,388
What Actually Drives Compound Growth
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Time is the biggest lever
Starting 10 years earlier can more than double your final amount. A 25-year-old investing $10k at 7% reaches $149k by 65. A 35-year-old reaches only $76k — half as much, despite only 10 fewer years.
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Regular contributions multiply fast
Adding $200/month to a $10,000 starting balance at 7% grows to $121,997 after 20 years — three times the $40,388 you'd get without contributions. Every recurring deposit benefits from all remaining years of compounding.
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Rate matters more than frequency
Switching from annual to daily compounding adds ~$1,800 on $10k at 7% over 20 years. But raising your return from 7% to 8% adds ~$9,000. Chasing a better investment return almost always beats optimising compounding frequency.
The Rule of 72 — A Quick Mental Shortcut
To estimate how long it takes your money to double, divide 72 by your annual interest rate. At 6% it doubles every 12 years. At 8% every 9 years. At 12% every 6 years. It's a useful sanity-check when comparing accounts, funds, or investment options without opening a calculator.
Frequently Asked Questions
What is the difference between compound and simple interest?
Simple interest is only calculated on your original principal. Compound interest is calculated on the principal plus all previously earned interest. Over 20 years, $10,000 at 7% simple interest returns $24,000 total. The same amount with monthly compounding returns $40,388 — a 68% difference that keeps widening over time.
How does compounding frequency affect my returns?
More frequent compounding means interest is added to your balance sooner, so it starts earning its own interest earlier. For $10,000 at 7% over 20 years: annually gives $38,697; monthly gives $40,388; daily gives $40,546. The differences are real but modest — the rate and time horizon have a far greater impact.
What annual return should I use?
The S&P 500 has historically averaged around 10% annually before inflation, or ~7% after. A diversified global portfolio typically returns 6–8% per year over the long term. For conservative planning use 5–6%. Always use the inflation rate field to see the real purchasing power of your future balance.
How can I track whether my real portfolio is hitting my projections?
A calculator shows what could happen under fixed assumptions. Real markets fluctuate, and your actual return will differ from year to year. FolioTrack lets you add your real holdings and see your actual performance against benchmarks like the S&P 500 — so you can tell whether you're on track, not just whether the maths says you should be.