How compounding actually works
Simple interest pays you only on the money you put in. Compound interest pays you on the money you put in plus all the interest you have already earned. That second part is what makes the curve bend upward instead of running in a straight line.
The effect is unremarkable in the early years and dramatic in the late ones. In the table above, notice how much interest accrues in the final year compared with the first. That final-year figure is usually several times larger, and it is earned without you contributing anything extra.
What return should you enter?
This depends entirely on where the money sits, and the difference between the options is enormous over twenty years.
- High-yield savings account: tracks short-term interest rates, so it moves with Federal Reserve policy. Principal is protected and FDIC-insured up to the coverage limit.
- Certificates of deposit: a fixed rate locked for a set term, usually slightly above savings rates in exchange for giving up access.
- Broad stock index funds: the long-run historical average after inflation is roughly 7 percent, but individual years have ranged from around −37 to +38 percent. Past performance does not predict future returns.
A word of caution on the stock market figure. Compound interest calculators produce an extremely smooth, extremely confident line. Real investment returns do not arrive that way, and the sequence in which good and bad years occur matters a great deal if you are drawing money out. Treat the output as a rough scale, not a forecast.
Inflation
The figures above are nominal, meaning they are not adjusted for inflation. If prices rise 2.5 percent a year, a balance of $500,000 in twenty years buys roughly what $305,000 buys today. One way to handle this is to enter a real return instead of a nominal one: subtract your inflation assumption from your expected return before typing it in.
Common questions
Does compounding frequency make a big difference?
Less than most people expect. Moving from annual to monthly compounding at 7 percent adds roughly 0.23 percentage points of effective annual return. Moving from monthly to daily adds almost nothing. The interest rate and the length of time matter vastly more than the compounding interval.
When are contributions added?
At the end of each period, which is the standard convention and the more conservative assumption. Contributing at the start of each period would produce a slightly higher balance.
Does this account for taxes or fees?
No. Investment returns in a taxable account are reduced by capital gains and dividend taxes, and fund expense ratios reduce them further. To approximate this, subtract your expected fee and tax drag from the return rate before entering it.
For general information only. This is not investment advice, and the projections shown are illustrative rather than predictive.