Compound interest is often referred to as interest on interest because it is “calculated on the sum loaned plus any interest that has accrued in previous periods” (check out the Oxford Dictionary of Business and Management, available online through Andersen Library, for more definitions like this). This is in contrast to simple interest, which only accrues interest on the principal amount.
Stick with me. That's a lot of financial jargon there, but understanding compound interest is critical if you want to save money and pay off debt efficiently. Compound interest is a two-edged sword. It’s a fantastic help when saving money and it’s a tremendous burden when you owe money. Here’s how compound interest works:
You start with $100 into a savings account, and add $10 each month. So at the end of the first year, you've put in $220 of your own money. But let's say the interest rate on your savings account is 6%, and the interest compounds monthly (or at a rate of 0.5% each month). So at the end of one year, you now have $229.52 -- that's an extra $9.52 in money you earned, just for saving!
That may not seem like much. However, continue to add $10 a month, and in 30 years you’ll have put in only $3,700 of your own money. But thanks to compound interest, your grand total is now about $10,647 (as long as you didn't take any money out). Wow!
Keep in mind that compound interest is also used in debt situations and the interest rates are usually higher. This means your debt will accumulate much faster than your savings. Check out the Compound Interest Calculator to the right to try out some of your own numbers.
Check out this video on compound interest from the St. Louis Federal Reserve.