What Is Compound Interest And How Does It Help Investors Build Wealth?

What Is Compound Interest And How Does It Help Investors Build Wealth?

Investing revolves around deploying cash in various asset classes, such as stocks, bonds, real estate, etc. However, the process also often leads to the accrual of residual income in the form of cash. Simply leaving your capital without a function makes it susceptible to inflation, which diminishes its purchasing power and essentially reduces your wealth. To combat this, many investors, regardless of their net worth, tend to use compound interest accounts to safeguard their residual cash assets. 

Compound interest accounts compound the general interest applicable to a deposit made in a bank, which leads to an increased annual yield on the principal deposit amount. This can be convenient in a myriad of ways; as not only do compound interest accounts protect capital from inflation, but also add to a decent profit on top. 

Compound interest accounts are some of the most popular deposit types made in global banks with a positive annual interest rate, which makes it all the more important for beginner investors to know how compound interest works and how it can help them build wealth in the long run. 

If you are one of such prospective investors - this investfox guide on compound interest is for you. 

How Does Compound Interest Work?

Compound interest accounts are financial accounts offered by banks or other financial institutions that allow you to earn interest on your initial deposit as well as on the accumulated interest over time. 

Key features of compound interest accounts include:

  • The initial deposit - this is the amount deposited to the account that the interest is paid towards
  • Interest calculation - the financial institution calculates the interest on your principal at a predetermined interest rate. This rate is usually expressed as an annual percentage rate (APR) and is divided into smaller compounding periods, such as monthly or daily
  • Compounding - at the end of each compounding period, the interest earned is added to the principal, effectively increasing the amount on which future interest calculations will be based. This new total becomes the new principal for the next compounding period
  • Repeated intervals - the process of compounding is repeated over the lifespan of the compound interest deposit 

Compound interests work to accumulate interest on the principal, as well as the interest paid on the principal, which means that with each new payment, the principal changes and includes the accrued interest up to the next date. 

Compound interest accounts have an edge over traditional deposit accounts, as their annual percentage rate tends to be higher. 

Calculating Compound Interest

Compound interest accounts operate using a simple compounding formula that is easy to calculate and involves the initial principal amount, interest rate, the number of times interest was applied per period, and the number of periods:

A = P(1+R/N)^NT


A = final amount

P = principal amount

R = interest rate

N = number of times interest is applied per time period

NT = number of time periods 

Manually calculating compound interest is not necessary, as deposit accounts will indicate the expected APR when opening the account. 

The compounding formula is useful for other types of investments as well, considering all profits are reinvested into an investment with a fixed annual interest rate. 

Compound VS Simple Interest

The typical bank deposit may offer an annual simple interest that is paid annually or in regular intervals, however, the annual yield does not exceed the terms agreed upon in the contract. 

For example, a simple interest account with an annual interest rate of 5% on a $10,000 principal would return $500 per year. 

Let’s assume that an investor is considering putting their spare cash in an interest-bearing account for 5 years with an annual interest rate of 5%. In the case of a simple interest account, they would have earned $2,500 in interest by year 5. 

Conversely, a compound interest account would have netted $2,762.8. 

While the difference may not seem so big at first, we must keep in mind that the effect of compounding interest goes into full effect after longer time frames. 

For instance, the same scenario over a 10-year period would yield the following returns:

Simple interest account - $5,000 by year 10

Compound interest account - $6,288.9 by year 10

The difference in this case is more than $1,288.9, which is an almost 13% difference in annual yield for the principal amount. The larger the time frame and annual interest rate - the more evident the effects of compounding become. 

How Can Investors Build Wealth With Compound Interest?

Building long-term wealth through compound interest can be tricky and involves some careful considerations, such as the annual rate of inflation and the probability of interest rate fluctuations. 

For example, during a regular year in the United States, the annual targeted rate of inflation is 2%, which means that any return above 2% would be netting a profit by the end of the year. 

Suppose an investor has $100,000 to spare and would like to invest in a basket of bonds with an average annual yield of 4% per year. If the investor holds it for 20 years, their returns would reach $219,112, which equals total returns in excess of 119% over the period. 

Now, while it is true that there are investments that can yield considerably more than 119% over 20 years, compound interest is geared toward cautious investors who wish to put their spare capital to work. 

Placing a portion of investment gains in compound interest accounts can be a great way of creating a safety net over the long haul - especially if interest rates are high. 

Common Compound Interest Periods

While the compounding periods offered by different financial institutions can vary greatly, certain types of instruments and financial accounts offer a comparable compounding period.

The compounding period depends on the type of investment and annual yield, as well as financial regulations upheld by relevant bodies to ensure the security and stability of the financial system. 

Furthermore, each financial instrument is geared for a specific time frame in mind, and longer investments that are typically less liquid are likely to compound on a quarterly, semiannual, or annual basis, while standard bank deposits compound daily. 

Some common interest compounding periods include:

  • Money market and savings accounts - banks commonly use a daily method of interest compounding
  • Credit cards - credit card interest is also mostly accrued daily, similar to bank deposits 
  • Loans - for most bank loans, interest is compounded on a monthly basis
  • Bonds - interest is compounded on a semi-annual basis
  • Certificate of deposit - compounding schedules for CDs range from daily to monthly

Choosing the right instruments is crucial in getting the most out of compounding and certain instruments can be subject to tax deductions and other benefits, which can lessen the overall tax burden for the year. 

What To Consider When Choosing A Compound Interest Account

Choosing the right compound interest account is important for maximizing the annual yield of your account. Banks may offer additional services that can make your investment experience more convenient. 

Some important factors to consider when choosing the financial institution to open a compound interest account with include:

  • Interest rate - arguably the most important factor. A higher interest rate means your investments will grow faster over time. Compare interest rates across different accounts and aim for the highest rate that aligns with your risk tolerance and investment goals
  • Compounding frequency - The more frequently the interest is compounded, the faster your investments will grow. Look for accounts that compound interest annually, semi-annually, quarterly, or even monthly for optimal growth
  • Account accessibility - some compound interest accounts may have fees or penalties for early withdrawals and it is important to review the terms and conditions closely 
  • Minimum balance requirements - some compound interest accounts have minimum balance requirements, which may vary significantly across different institutions. Ensure that you can meet the minimum balance requirement without straining your finances
  • Account fees - be aware of any fees associated with the compound interest account. These can include maintenance fees, transaction fees, or early withdrawal penalties. Minimizing fees is important to maximize your returns, so choose an account with reasonable or no fees
  • Deposit and withdrawal options - consider the flexibility of adding funds to or withdrawing from your account. Setting up automatic deposits and withdrawals can be especially convenient and useful
  • Financial institution reputation - the experience and reputation of the institution can play a significant role in the services they offer and the safety of your funds. Make sure that they have a long history of operations and no major controversies or legal issues
  • FDIC insurance - deposits in the United States are insured by the Federal Deposit Insurance Corporation (FDIC), which covers up to $250,000 per depositor 
  • Taxes - consider the tax implications of the compound interest account. The interest earned may be subject to income tax. Evaluate whether the account qualifies for any tax advantages, such as an individual retirement account (IRA) 
  • Additional features - some compound interest accounts offer additional features, such as the ability to link with investment accounts, automatic reinvestment options, or rewards programs

Assessing the aforementioned factors can help you choose the best compound interest account for your investment needs to keep your cash secure and growing in the long run. 

Pros & Cons Of Compound Interest

Before picking a specific compound interest account with a bank or other financial institution, it is important to carefully consider the inherent advantages and disadvantages associated with keeping your capital in a compound interest account to assess whether this is the right course of action for your objectives. 


  • Accelerated growth - compound interest accounts pay interest on both the principal amount and the interest paid, which accelerates the process of growth and leads to a higher annual yield on your capital 
  • Passive income - compound interest accounts provide a passive investment approach. Once you deposit funds into the account, the compounding process happens automatically without requiring active management or frequent investment decisions. This makes compound interest accounts suitable for investors who prefer a hands-off approach
  • Diversification - compound interest accounts can offer a low-risk investment option for diversifying your portfolio. They can be used alongside other investments like stocks, bonds, or real estate to spread risk and stabilize returns
  • Long-term wealth accumulation - compound interest accounts can help investors accumulate wealth in the long run and achieve specific financial plans, such as retirement and education savings, etc


  • Low interest rates - compound interest accounts are especially effective when interest rates are higher. Low interest rates will provide limited returns in the long term. It is important to balance your investment portfolio and not rely solely on compound interest accounts 
  • Inflation risk - inflation is unlikely to remain uniform over the long term, which creates the risk of annual interest returns not being enough to maintain the purchasing power of the principal deposit amount. While compound interest accounts can help mitigate inflation losses, it is unlikely to fully cover them during periods of high inflation
  • Limited liquidity - some compound interest accounts have restrictions on withdrawals or early redemption penalties. This lack of immediate liquidity can be a disadvantage if you need access to your funds in emergencies or for short-term expenses
  • Opportunity cost - the funds placed in a compound interest account could be used for investments with a higher annual return, which gives it a high opportunity cost. Allocating a portion of your portfolio to investments with a higher annual return can help combat this 
  • Taxes - the interest earned in compound interest accounts is generally subject to income tax. Depending on your tax bracket and the prevailing tax laws in your jurisdiction, the tax burden can reduce your overall returns

Key Takeaways From What Is Compound Interest And How Does It Help Investors Build Wealth

  • Investors can put their spare capital to good use with compound interest deposits, which are offered by most banks and financial institutions around the world
  • Compound interest is the interest earned on both the initial principal amount and any accumulated interest that has been reinvested
  • Compound interest can significantly boost savings and investments over time. By reinvesting the earned interest, your initial savings or investments grow at an accelerating rate, allowing for greater wealth accumulation and reaching financial goals faster
  • Some compound interest accounts may have minimum balance requirements, limited liquidity, or lower interest rates compared to more aggressive investment options
  • Compound interest accounts can work in tandem with a traditional investment strategy to help balance the risk exposure of the portfolio 

FAQs On Compound Interest

Is compound interest worth it?

Compound interest accounts can be a great way for investors to put their spare cash to work. Compound interest is generally beneficial, especially for long-term investments. However, it's important to consider the interest rate, inflation, taxes, and investment duration. 

How does compound interest work?

Compound interest accounts accrue interest on the principal amount as well as the interest. Each interest-bearing installment assumes the principal amount alongside the already accrued interest on that principal. 

Is compound interest better than simple interest?

Simple interest is calculated solely on the initial principal amount, whereas compound interest takes into account both the principal and any previously earned interest. As a result, compound interest generates higher returns over time compared to simple interest.