How It Works Step by Step
When you put money in a savings account or investment, the bank pays you interest. With compound interest, that interest gets added to your original amount. The next time interest is calculated, it's based on the larger total. This means you're earning interest on interest, which causes your money to grow faster. The more often interest compounds, the faster your money grows.
Simple Interest vs Compound Interest
Simple interest only pays interest on the original amount you put in. Compound interest pays interest on the original amount plus all the interest that has been added. For example, $1,000 earning 5% simple interest makes $50 every year. But $1,000 earning 5% compound interest makes $50 the first year, then $52.50 the second year, then $55.13 the third year, and so on. Over time, compound interest creates much bigger differences.
Where Compound Interest Happens
Compound interest occurs in savings accounts, money market accounts, certificates of deposit (CDs), bonds, and investment accounts. It also happens when you borrow money for loans or credit cards, but in those cases the interest works against you. Banks and credit card companies use compound interest to calculate what you owe them.
The Power of Time
The biggest factor in compound interest is how long your money has to grow. Even a small interest rate can create huge amounts of money if you give it 20, 30, or 40 years to compound. This is why starting to save early, even with small amounts, can lead to much larger sums by retirement. A person who invests $100 per month starting at age 25 will have significantly more money at age 65 than someone who invests $200 per month starting at age 45.
How Often Interest Compounds
Interest can compound daily, monthly, quarterly, or annually. The more frequently interest compounds, the more interest you earn. Daily compounding is better than annual compounding because your interest starts earning interest more often. However, the difference between daily and monthly compounding is usually small for savings accounts. 
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