Compound Interest Explained Simply

Interest on interest

Compound interest means earning interest on your original money and on interest already added to it. The original amount is called the principal. Once interest is added, it becomes part of the balance on which later interest is calculated. That is the mechanism explained by the CFPB.

Think of it as a growing base: the next calculation can start from a larger amount than the previous one. The rate, time and frequency of compounding all matter. Comparing daily and annual compounding only makes sense when the other assumptions are comparable; frequency alone does not tell you which account is better. CFPB.

A hypothetical example, not a promised return

Suppose €1,000 earns a fixed 5% each year, with interest added annually and no fees, taxes, withdrawals or extra deposits. After one year: €1,000 × 1.05 = €1,050. After two: €1,050 × 1.05 = €1,102.50. The second year earns €52.50 rather than €50 because the first year's interest also earns interest. These are invented teaching assumptions, not a current offer or forecast; the mechanism follows the CFPB explanation.

Two common questions

How is simple interest different? It is calculated on the original principal, without adding earlier interest to the base. Compound interest includes that earlier interest. This difference explains the example above. CFPB.

Is time enough on its own? No. Time allows repeated calculations, but the rate and account conditions also matter. A compounding example explains arithmetic; it is not evidence that an investment will earn a fixed return. Read the assumptions before interpreting any projection. CFPB.

Explore a hypothetical portfolio in the simulator and continue with how much to invest each month.

Sources

• CFPB — How does compound interest work?

This article is for educational purposes only and does not constitute financial advice.