How Compound Interest Works

Tina asks Dave to explain how compound interest works.

QUESTION: Tina on Twitter asks Dave to explain how compound interest works.

ANSWER: Let’s use some very simple math. Let’s pretend 10%—and that would be seriously pretend—interest, and let’s pretend you put $1,000 in the bank. At the end of the year, 10% of $1,000 would be $100. They would deposit $100 to that account. If you were to leave the money in that account, you’d have $1,100. If you got 10% on $1,100, the interest would be $110 instead of $100. So now we have $1,210 left in the account. The next year, your interest would no longer be $110. It would be $121. Each year, the interest is getting interest not only on the original $1,000 principal you put in but on the interest that has grown since then. So it’s interest on the interest on the interest on the interest… It compounds. It builds up. It snowballs. Every time the snowball rolls over, it picks up more snow because the snowball is bigger. The more you leave the money alone and let it grow, the more it grows. And of course, the bigger the interest rate, the faster it will grow. Rate matters a lot. Or the rate of growth—if it’s not an interest rate—like with a mutual fund.