Compound interest (compounding)
Compound interest means earning interest not only on the money you put in, but also on the interest already added. The growth your money earns starts earning its own growth, year after year. This is called compounding, and the longer it runs, the faster the total grows.
Simple and compound interest
With simple interest, you earn on the original amount only, so each year adds the same sum. With compound interest, each year's interest is added to the pile, and the next year's interest is worked out on that bigger pile. The rate did not change. The base it applies to did.
The formula
Final amount = P x (1 + r) to the power n, where P is the money you start with, r is the rate for one period written as a decimal, and n is the number of periods. Interest is credited on a schedule, such as every year or every quarter, and the more often it is added, the slightly faster the total grows.
Why time matters more than the amount
Compounding looks slow at first and then speeds up, because the growth in a single year is applied to an ever larger base. That is why a smaller amount with a long runway can end up ahead of a larger amount with a short one. Early money has more years for growth to build on growth.
It works against you on debt
The same arithmetic applies to money you owe. Unpaid interest on a loan or a credit card balance can be added to what you owe, and then interest is charged on the larger total. Compounding helps savers and costs borrowers.
Simple against compound (hypothetical numbers)
Suppose you put ₹10,000 away at 10 percent a year. After one year you have ₹11,000, a gain of ₹1,000. After two years, simple interest gives ₹12,000, because it adds ₹1,000 each year. Compound interest gives ₹12,100, because the second year's 10 percent is worked out on ₹11,000. The gap looks small now, but it keeps widening every year.
Common questions
- What is compound interest in simple words?
- Interest that is earned on your earlier interest as well as on the money you first put in.
- What is the difference between simple and compound interest?
- Simple interest is worked out on the original amount only. Compound interest is worked out on the original amount plus the interest already added.
- Is compounding only for savings?
- No. The same effect applies to debt, where unpaid interest can be added to the amount owed.
- Does compounding guarantee a return?
- No. The arithmetic is exact for a fixed rate, but the returns of most investments are not fixed and can be lower or negative.