What Is Compound Interest?

April is Financial Literacy Month, and our goal is to help you raise your money IQ. In this series, we'll tackle key economic concepts -- ones that affect your everyday finances and investments -- to help you make smarter choices with every dollar decision you face.

Today's term: compound interest.

The concept of interest is familiar to most of us. We know that with many bank accounts, for example, we earn some interest -- though it's rather paltry these days.

But there are several kinds of interest that are calculated and represented quite differently than simple interest. Compound interest is -- pardon the pun -- one of the more interesting ones.

First, let's start with simple interest. Here's how it works: Let's say that you've parked $1,000 in an account somewhere, earning 10 percent per year in simple interest. In year one, you'll collect $100, bringing your total to $1,100. Great, eh? In year two, you get... $100. That brings your total to $1,200. In year three, you're at $1,300. You're probably catching on to the idea by now. You keep earning that interest rate off your initial principal.

Small numbers become big numbers

Enter compound interest, which is far more exciting.

Start again with $1,000 and factor in an annual 10 percent compound interest rate. In year one, you get $100, for a total of $1,100. In year two, though, you collect that 10 percent not only on your original principal amount, but also on the interest you've already earned – on the whole $1,100. So you earn $110, instead of the $100 that simple interest gave you, bringing your total to $1,210. In year three, you collect $121 instead of $100, for a total of $1,331 instead of $1,300. In year four, you earn $133, bringing your total to $1,464 instead of the $1,400 you'd have earning simple interest.

The key thing to observe in this example is that not only is your overall total investment growing from year to year, but the amount by which it's growing is also increasing.

Now check out how powerful that 10 percent compound interest rate is over time, because when you combine compounding with years, the magic really happens:

Compound interest in your life

That kind of growth may seem magical, but it's not magic -- it's just math.

You don't need to wait around for an every-so-many-years environment of steep interest rates, either. If you invest in stocks or some other appreciating asset, your investment can compound over time even if it does not deliver the same return every single year. In that case, you'll be looking at an average rate of growth over time.

Over many decades, for example, the U.S. stock market has grown by an annual average of about 10 percent. Some periods it may average as little as 5 percent, and in others as much as 12 percent, but over long periods, it has generally grown.

There are other examples of compounding having a positive long-term effect. Knowledge, for example, builds on itself. The more you learn, the more you can learn. Once you understand some basics of biology, or French, or politics, you will be able to learn and understand more.

Of course there is a darker side of compounding, where ill effects compound. Epidemics are one example: Each infected person can infect more people, who can then infect even more people. Another dark side is the way your credit card debt can spiral out of control with hefty interest charges applied to an ever-growing balance due.

Focus on the positive, though, and put compounding to work for you in the best ways. Let it contribute to a comfortable retirement, for example. For that, you just need a solid expected growth rate and enough time.

Learning about some simple economic concepts can make you a better financial thinker and decision maker.

More money terms:
Cash flow
Asset allocation
Opportunity cost

See all money terms to know.

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