The Difference Between Simple and Compound Interest
With simple interest, you earn a percentage of your original deposit each year — always calculated on the starting amount. With compound interest, you earn interest on your current balance, which includes interest you have already earned. Your interest earns interest. This causes your savings to grow at an accelerating rate rather than a flat, steady line.
A Simple Example
Suppose you save 1,000 euros at 5% interest compounded annually. After year one you earn 50 euros, giving you 1,050. In year two, the 5% is calculated on 1,050 — so you earn 52.50 euros. In year three, interest is calculated on 1,102.50, and so on. After 10 years your 1,000 euros grows to approximately 1,629 euros. After 30 years, it exceeds 4,300 euros. The longer the timeframe, the more dramatic the effect becomes.
Why Time Is the Most Important Factor
The most powerful aspect of compound interest is that its effect grows exponentially with time. Someone who saves consistently from age 25 will accumulate significantly more than someone who starts at 35 with the same monthly contributions — even though the difference is only 10 years. The extra decade of compounding creates a gap that is very hard to close later on.
How Compounding Frequency Affects Growth
Interest can be compounded annually, quarterly, monthly, or daily. The more frequently it compounds, the faster your balance grows. For most savings accounts, interest is compounded monthly or daily. The difference between monthly and daily compounding is relatively small, but the difference between annual and monthly compounding can be meaningful over longer periods.
The Effect of Regular Contributions
Compound interest becomes even more powerful when combined with regular deposits. Adding a fixed amount to your savings each month constantly increases the base on which interest is calculated. Over time, the combination of regular contributions and compounding produces results that can feel surprising when you first model them with a savings calculator.
Compound Interest on Debt
It is worth remembering that compound interest works in both directions. When you are a saver, it works in your favour. When you are a borrower, it works against you. High-interest debt — particularly credit card balances — can grow quickly because interest is added to the outstanding balance, and then interest is charged on that larger balance in the next period. This is why minimum payments on credit cards can keep you paying for far longer than expected.
Estimate Your Savings Growth
You can model how your savings could grow over time using the free Savings Calculator on this site. Enter your starting amount, monthly contribution, interest rate, and time period to see your projected balance.
This article is for general informational purposes only and does not constitute financial advice. Returns depend on interest rates and other factors that can change over time.
