Compound interest is almost like magic. It makes dollars multiply before your eyes.
Let’s say you start with $1,000 in the bank. If the interest rate is 4%, you’ll have $40 more in the account at the end of the year. That’s simple interest. But in a year or two, you earn interest not just on the original $1,000, but also on the $40 in interest you’ve already earned.
In other words, your interest earns interest. That’s compound interest. And as long as interest rates don’t fall, the amount you receive in interest grows each year you keep your money in the bank.
The same principle works when you invest in stocks or mutual funds, where annual returns are, on average, higher than they are at the bank. With compounded returns, the money your investments earn one year will earn money for you in following years — as long as you reinvest it.