Frequently Asked Questions
What is compound interest?
Compound interest is interest calculated on both the initial principal and the accumulated interest from previous periods. Unlike simple interest, which is only calculated on the principal, compound interest causes your money to grow exponentially over time. The more frequently interest compounds, the faster your balance grows.
How does compound interest differ from simple interest?
Simple interest is calculated only on the original principal amount. Compound interest is calculated on the principal plus all previously earned interest. Over time, compound interest produces significantly higher returns because each period's interest earns interest in subsequent periods. For example, $10,000 at 7% simple interest earns $700/year. At 7% compound interest, the earnings grow each year as your balance grows.
What is the compound interest formula?
The compound interest formula is A = P(1 + r/n)^(nt), where A is the final amount, P is the principal, r is the annual interest rate (as a decimal), n is the number of times interest compounds per year, and t is the number of years. When you add monthly contributions, the formula includes an additional term: PMT × [((1 + r/n)^(nt) - 1) / (r/n)].
How does compounding frequency affect returns?
More frequent compounding produces slightly higher returns. Daily compounding yields the most, followed by monthly, quarterly, and annually. However, the difference between daily and monthly compounding is usually small — often less than 0.1% per year at typical interest rates. For example, $10,000 at 7% compounded annually gives $10,700 after one year, while daily compounding gives $10,725 — a difference of just $25.
What is the Rule of 72?
The Rule of 72 is a quick estimation method: divide 72 by your annual interest rate to estimate how many years it takes to double your money. For example, at 6% interest, your money doubles in approximately 72 ÷ 6 = 12 years. At 8%, it doubles in about 9 years. This rule works best for interest rates between 4% and 12%.
How much should I invest monthly to reach my goal?
A common guideline is to invest 15-20% of your income. Use this calculator's monthly contribution field to experiment with different amounts. The earlier you start, the less you need to contribute monthly because compound interest does more of the heavy lifting over longer time horizons. Even small monthly contributions can grow substantially over decades.
What is effective annual interest rate?
The effective annual rate (EAR) is the actual interest rate you earn after accounting for compounding within the year. For example, a 6% rate compounded monthly gives an EAR of about 6.17%. The formula is EAR = (1 + r/n)^n - 1, where r is the stated annual rate and n is the number of compounding periods per year. Always compare accounts using EAR for an accurate picture.
Is compound interest taxed?
Yes, interest earned through compound interest is generally taxable as ordinary income in the year it is earned. However, tax-advantaged accounts like IRAs, 401(k)s, and 529 plans can shelter compound interest from taxes, allowing your money to grow faster. Tax-deferred growth is one of the biggest advantages of retirement accounts.
How does inflation affect compound interest?
Inflation reduces the purchasing power of your returns. If your investment earns 7% compound interest but inflation is 3%, your real return is approximately 4%. Always compare your investment returns to inflation to understand your true growth in purchasing power. The stock market has historically returned about 10% nominal and 7% real (after inflation).
What is the difference between APY and interest rate?
The interest rate (or APR) is the stated rate before compounding. APY (Annual Percentage Yield) is the effective rate after accounting for compounding. APY is always equal to or higher than the stated rate. When comparing savings accounts or investments, always look at APY — it gives you the true picture of what you'll actually earn over a year.