What Is Compound Interest?
Compound interest is interest calculated on both the initial principal and the accumulated interest from previous periods, meaning an investment or savings balance grows at an accelerating rate over time compared to simple interest, which is calculated only on the original principal.
How Compound Interest Works
Each time interest is added to an account, the next period’s interest is calculated on the new, larger balance. Over long periods, this compounding effect can produce dramatically larger returns than simple interest, especially when returns are reinvested consistently.
Simple vs. Compound Interest Over Time
What Is the Rule of 72?
The Rule of 72 is a quick mental shortcut for estimating how long it will take an investment to double in value, calculated by dividing 72 by the annual rate of return. For example, at a 6% annual return, an investment would take approximately 12 years to double (72 ÷ 6 = 12).
Rule of 72: Estimated Years to Double
| Annual Return | Years to Double (Approx.) |
|---|---|
| 3% | 24 years |
| 6% | 12 years |
| 8% | 9 years |
| 10% | 7.2 years |
| 12% | 6 years |
Why Starting Early Matters
Because compounding accelerates over time, starting to invest early can have an outsized impact on long-term wealth, even if the amount invested is modest, since each additional year gives returns more time to compound on themselves.
Frequently Asked Questions
Is the Rule of 72 exactly accurate?
The Rule of 72 is an approximation, most accurate for annual interest rates roughly between 6% and 10%. For rates far outside this range, the estimate becomes less precise compared to a full compound interest calculation.
How often does interest need to compound to matter?
Compounding frequency, whether annual, monthly, or daily, affects the total return, with more frequent compounding generally producing slightly higher returns, though the difference is usually modest compared to the impact of time and rate of return.
Does compound interest apply to debt as well as investments?
Yes, compound interest works the same way for debt, such as credit card balances, meaning unpaid interest gets added to the principal and future interest is charged on the larger balance, which can cause debt to grow quickly if left unpaid.
What is an example of compound interest in investing?
Reinvesting dividends from a stock or fund is a common example, since each reinvested dividend buys additional shares, which then generate their own dividends in future periods, compounding returns over time.
Key Takeaways
Compound interest allows returns to build on both the original principal and previously earned interest, producing accelerating growth over time compared to simple interest. The Rule of 72 offers a quick way to estimate how long an investment takes to double, reinforcing the importance of starting to invest early and letting compounding work over a long time horizon. This article is for informational purposes only and does not constitute investment advice.
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