Compound Interest
Compound interest means earning returns on your earlier returns as well as on the original amount. At 10% a year, $1,000 grows to $1,100 after one year and $1,210 after two, because the second year's interest is also paid on the first year's $100.
Compounding is the quiet engine behind long-term wealth: returns are added to the balance and then earn returns of their own. In the early years the effect looks small; over decades it does most of the work. It runs in reverse too — on debt, on fees and on losses. This entry shows how compounding works, how to estimate it quickly and what it means for traders.
- Category
- Trading Basics
- Reading time
- 4 min
- Also called
- Compounding, Compound returns, Interest on interest
- Updated
Compounding in plain words
Compound interest is interest paid both on the original principal and on the interest already earned.1
Leave $100 to grow at 5% a year without adding anything and it becomes more than $162 after 10 years and almost $340 after 25.2
How often interest is added matters too — yearly, monthly or daily compounding gives slightly different results.3
How compounding works, step by step
Start with a principal
The amount you invest or save.
Earn a return
Interest, dividends or price gains for the period.
Add it to the balance
Reinvest instead of spending. See Dividend Reinvestment Plan.
Earn on the bigger balance
Next period's return is calculated on principal plus past returns.
Repeat for many periods
Growth accelerates the longer it runs.
Estimate with the Rule of 72
72 ÷ the yearly rate ≈ years to double. See Rule of 72.
Worked examples
Example 1 — Simple vs compound
+$11 extraYou invest $1,000 at 6% a year for 3 years.
| Simple interest | $1,000 + 3 × $60 = $1,180 |
| Compound | $1,000 × 1.06³ ≈ $1,191 |
| Extra from compounding | ≈ $11 |
Compound interest pays on past interest as well as on the principal, so it pulls ahead of simple interest.1
Example 2 — Time does the heavy lifting
More than triplesYou leave $100 at 5% a year.
| After 10 years | $100 × 1.05¹⁰ ≈ $163 |
| After 25 years | $100 × 1.05²⁵ ≈ $339 |
With no extra money added, the balance more than triples in 25 years.2
Example 3 — Compounding works against you
−47%A trader loses 10% a month for 6 months on $10,000.
| Balance | $10,000 × 0.9⁶ ≈ $5,314 |
| Loss | ≈ −$4,686 (−47%) |
| Gain needed to recover | ≈ +88% |
Losses compound too: each month's loss applies to a smaller balance, and recovering takes a much larger gain. See Drawdown.
Simple vs compound interest
| Aspect | Simple | Compound |
|---|---|---|
| Interest paid on | Principal only | Principal plus past interest |
| Growth shape | Straight line | Accelerating curve |
| Effect of time | Proportional | Much stronger over long periods |
| Example: $1,000 at 6% for 3 years | $1,180 | ≈ $1,191 |
Where compounding matters
Long-term investing
Reinvesting dividends and gains. See Buy and Hold.
Comparing returns
Annualised returns assume compounding. See Compound Annual Growth Rate.
Fees
A 1% yearly fee compounds into a large slice of long-run returns. See Expense Ratio.
Trading accounts
Growing position size with the account compounds gains — and losses.
Advantages and disadvantages
Advantages
- Lets small, regular returns grow into large sums.
- Rewards starting early and staying invested.
- Easy to estimate with the Rule of 72.
Disadvantages
- Works the same way on debt, fees and losses.
- Needs time; early years look unimpressive.
- Assumes returns are reinvested, which real life often interrupts.
Going deeper
Read as far as you need. Each level builds on the one before it.
The Rule of 72
Beginner
To estimate how long money takes to double, divide 72 by the yearly return: at 8% that is about 9 years.2 See Rule of 72.
The formula
Intermediate
Future value = principal × (1 + rate per period) raised to the number of periods. More frequent compounding means a slightly higher result for the same yearly rate.3 See Present and Future Value and APR and APY.
Compounding and volatility
Advanced
Because returns multiply, swings cost money: +20% then −20% leaves you 4% down. That “volatility drag” is why steadier returns compound faster than wild ones with the same average. See Volatility.
Common mistakes
Starting late
Ten extra years of compounding often matter more than higher contributions.
Withdrawing the gains
Spending returns stops them compounding.
Ignoring fees
Costs compound too and quietly shrink the result.
Averaging returns arithmetically
+50% and −50% is not break-even — it is a 25% loss.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- Compounding earns returns on past returns.
- Time is the biggest driver.
- The Rule of 72 estimates doubling time.
- Fees and losses compound too.
- Reinvesting keeps the effect going.
Frequently asked questions
Is compound interest only for savings accounts?
Does compounding work on debt?
How often is interest compounded?
Further learning
- Compound Annual Growth Rate
How compound growth is measured.
- APR and APY
Rates with and without compounding.
- Drawdown
Why compounded losses are hard to recover.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Investor.gov (SEC). Compound Interest (glossary) (opens in a new tab) Checked .
- Investor.gov (SEC). What is compound interest? (opens in a new tab) Checked .
- Investor.gov (SEC). Compound Interest Calculator (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.