How Does Compound Interest Work — In Plain Words

This page is educational only. It is not financial advice.

Short answer

Compound interest is when you earn interest on the money you have saved and on the interest you earn along the way. That is the Consumer Financial Protection Bureau (CFPB) wording.

Simple interest is different. As the SEC Investor Bulletin on Brokered CDs states it, simple interest is only based on the original amount you placed in the CD, while compound interest is based on the original amount you placed in the CD plus any accumulated interest you receive through the CD’s maturity date.

This page is about how interest on deposits and CDs is calculated, using the account terms and the worked examples in the two sources named in the Sources box. It prints what those sources state, in plain words.

What this page covers

This page explains, from those two sources only:

• What simple interest is and what compound interest is
• What it means for interest to earn interest
• The CFPB worked example: $1,000 at 5 percent, calculated once a year
• The Brokered CDs bulletin’s 5-year table comparing simple interest and compound interest
• How often interest is calculated or paid, as each source describes it

Simple interest compared with compound interest

Simple interest (Brokered CDs bulletin): interest based only on the original amount you placed in the CD.

Compound interest (Brokered CDs bulletin): interest based on the original amount you placed in the CD plus any accumulated interest you receive through the CD’s maturity date.

Compound interest (CFPB): you earn interest on the money you have saved and on the interest you earn along the way.

Put in plain words, the difference is the amount the interest rate is applied to. With simple interest, the rate is applied to the original amount each time. With compound interest, the rate is applied to the original amount plus interest already added.

Interest earning interest: the CFPB example

The CFPB example uses these terms:

• Amount you start with: $1,000. The CFPB also calls this your principal.
• How much you earn: 5 percent. The CFPB also calls this your interest rate, or rate of return.
• How often you calculate interest: once a year. The CFPB also calls this your compounding frequency.

After the first year:

• 0.05 x $1,000 = $50
• $1,000 + $50 = $1,050
• Amount after the first year: $1,050

After the second year, the 5 percent is applied to $1,050, not to $1,000:

• 0.05 x $1,050 = $52.50
• $1,050 + $52.50 = $1,102.50
• Amount after the second year: $1,102.50

The extra $2.50 in the second year is interest calculated on the first year’s $50 of interest. That step — interest calculated on interest already added — is what makes the interest compound instead of simple.

The 5-year comparison in the Brokered CDs bulletin

The bulletin’s example compares $1,000 at an annual interest rate of 5 percent under simple interest and under compound interest over a 5-year period. The bulletin’s table states:

• Initial savings: $1000 under simple interest; $1000 under compound interest
• Value end of year 1: $1050 under simple interest; $1050 under compound interest
• Value end of year 2: $1100 under simple interest; $1102.50 under compound interest
• Value end of year 3: $1150 under simple interest; $1157.63 under compound interest
• Value end of year 4: $1200 under simple interest; $1215.51 under compound interest
• Value end of year 5: $1250 under simple interest; $1276.28 under compound interest

The bulletin explains the table this way:

• After the first year, both accounts receive an interest payment of $50 (5% x $1000) and have a total value of $1050.
• With simple interest, you only earn annual interest on $1000 each year.
• With compound interest, you earn annual interest on $1000, and the interest accumulated from previous years.
• In year 2, instead of earning interest on just $1000, you earn interest on $1050, which gives you an extra $2.50 of interest at the end of year 2.
• This compounding effect continues through year 5 and results in an extra $26.28 of interest after 5 years.

How this applies to CDs

The bulletin states that a brokered CD usually pays interest at regular intervals (for example, monthly, quarterly, or semi-annually).

The bulletin also states that, unlike CDs purchased directly from a bank, brokered CDs generally pay simple interest rather than compound interest.

Instead of allowing interest to accumulate and compound inside the CD, brokered CDs pay interest out to the CD holder in cash at a specified interval.

The bulletin states that to earn interest on a brokered CD’s interest payments, you must reinvest these funds in another account.

The bulletin’s opening section also states the basic CD terms it uses: a CD is a special type of deposit account with a bank that typically offers a higher rate of interest than a regular savings account. When you purchase a CD directly from a bank, you invest a fixed sum of money for a fixed period — generally anywhere from six months to five years — and, in exchange, the issuing bank pays you interest, typically at regular intervals. When you cash in or redeem your CD, you receive the money you originally invested plus any accrued interest.

How often interest is calculated or paid

The two sources describe timing in two different ways, so each is stated in its own passage here.

As the CFPB describes it: the CFPB calls how often you calculate interest your compounding frequency. In the CFPB worked example above, interest is calculated once a year.

As the Brokered CDs bulletin describes it: a brokered CD usually pays interest at regular intervals (for example, monthly, quarterly, or semi-annually), and brokered CDs pay interest out to the CD holder in cash at a specified interval.

This page is educational only. It is not financial advice.