Compound Interest Explained: A Simple Example
By Beacon · Updated · 3 min read
Compound interest means interest can earn interest of its own when it stays in the account. The balance grows from both the original amount and earlier interest. Investment growth can also compound, but market returns vary and can be negative; a smooth example is not a forecast.
Follow the first three years
Assume a $1,000 starting balance, 5% annual interest, compounding once a year, no withdrawals, no additional deposits, and no fees or taxes. In year one, $50 of interest brings the balance to $1,050.
In year two, the same 5% is applied to $1,050, producing $52.50. The additional $2.50 comes from earning interest on the first year’s $50. No higher rate was needed for the dollar amount to increase.
| Year | Starting balance | Interest | Ending balance |
|---|---|---|---|
| 1 | $1,000.00 | $50.00 | $1,050.00 |
| 2 | $1,050.00 | $52.50 | $1,102.50 |
| 3 | $1,102.50 | $55.13 | $1,157.63 |
Compare compound and simple interest
With annual compounding and no deposits, the formula is starting amount × (1 + annual rate) raised to the number of years. Enter 5% as 0.05, not 5. After ten years, $1,000 × 1.05^10 is approximately $1,628.89.
Simple interest at the same assumed rate on the original $1,000 would add $50 each year, ending at $1,500 after ten years. The $128.89 difference illustrates the effect of leaving earlier interest available to earn more interest.
Separate contributions from growth
A rising balance is not all investment growth. Deposits can account for much of it, especially early on. Keeping those two amounts separate makes a projection easier to understand.
For an independent example, start at $0 and contribute $100 at the end of each month for ten years. Assume a nominal 5% annual rate divided into 12 monthly periods. The model ends at about $15,528.23: $12,000 in deposits and $3,528.23 of modeled growth, before fees and taxes.
Treat a projection as a scenario
A savings product’s stated terms and an assumed investment return are different things. An investment model using the same percentage every month leaves out market fluctuations. Fees, taxes, and inflation also affect what the ending amount is worth.
To understand the model, change one assumption at a time. Try a smaller contribution, a shorter timeline, or a lower return. Notice which changes come from money you contribute and which come from the assumed growth. The goal is understanding the relationship, not choosing a pleasing final number.
- Write down the initial amount and deposit schedule.
- Check whether deposits happen at the start or end of a period.
- Name the compounding frequency and assumed rate.
- Compare several scenarios and note what each excludes.
Calculators for this guide
Terms in this guide
Sources and further reading
- Investor.gov: What is compound interest?
- Investor.gov: Compound interest calculator
- Investor.gov: Introduction to investing
Examples are illustrative and focus on U.S. personal finance. This guide is educational, not individual financial, investment, tax, or legal advice. Read our editorial approach or report a correction.
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