How does compound interest work, with a simple example?

Compound interest is essentially "interest on interest." Instead of only earning money on your initial deposit, you also earn money on the interest that has accumulated in previous periods. Over time, this creates a snowball effect that helps your savings grow significantly faster than they would with simple interest.

Here is a simple example to show how it works:

Imagine you deposit $100 into a savings account that pays 10% interest per year.

• Year 1: You earn 10% on your $100, which is $10. Your total balance is now $110.
• Year 2: You now earn 10% on your new balance of $110. That equals $11 in interest. Your total balance is now $121.
• Year 3: You earn 10% on $121, which is $12.10. Your total balance is now $133.10.

The difference: If you were using simple interest (where you only earn interest on the original $100 every year), you would have earned $10 each year, leaving you with $130 after three years. With compound interest, you have $133.10.

While $3.10 might seem small, that gap widens significantly the longer your money stays in the account and the higher the interest rate becomes. This is why starting early is often considered one of the most effective ways to build long-term savings.