Compound Interest
Compound interest is the process by which interest (or investment returns) is earned not only on the original principal but also on all previously accumulated interest, causing wealth to grow at an accelerating rate over time.
Albert Einstein is often — likely apocryphally — credited with calling compound interest the eighth wonder of the world. Whether he said it or not, the underlying mathematics genuinely are remarkable. Compound interest transforms modest, consistent saving into substantial wealth through the simple mechanism of earning returns on returns.
The contrast with simple interest illustrates the power. With simple interest, $10,000 invested at 7% per year earns $700 every year, and after 30 years the account totals $31,000. With compound interest at the same 7% annual return, the account grows to approximately $76,123 — more than two and a half times more — because each year's gains are reinvested and begin earning their own returns.
Compounding frequency matters. Interest can compound annually, quarterly, monthly, or daily. More frequent compounding produces slightly higher effective returns because gains are reinvested sooner. Most brokerage accounts and high-yield savings accounts compound interest daily or monthly, which maximizes the compounding benefit.
For American investors using index funds and ETFs, compound interest manifests through dividend reinvestment. When an ETF distributes quarterly dividends and you reinvest them — either manually or through an automatic dividend reinvestment plan (DRIP) offered by brokers like Fidelity, Schwab, and Vanguard — those reinvested shares begin generating their own dividends the next quarter. Over decades, reinvested dividends can account for a majority of total portfolio value.
The most powerful factor in compounding is time. Starting early is dramatically more valuable than starting with a larger amount later. An investor who contributes $5,000 per year from age 22 to 32 (10 years, $50,000 total) and then stops will, at a 7% annual return, end up with more at age 65 than someone who contributes $5,000 per year from age 32 to 65 (33 years, $165,000 total). The early starter simply had more years of compounding working in their favor.