Compound interest is one of the strongest forces in personal finance! But strong as it is, it’s fair to ask, “what is compound interest?” Compound interest is interest you’ve earned on your original savings deposit in addition to the interest you have already accumulated. So… interest on top of interest? Exactly! In this blog we will do a deeper dive into what compound interest is, how it works, provide a real example, and share how to make it beneficial to you. 

What Is Compound Interest?

Compound interest is interest you accumulate from an initial deposit amount and previously accumulated interest. Compound interest is different from simple interest. If you’re wondering what the difference between simple interest and compound interest is, the following table of information can help explain: 

	Simple Interest	Compound Interest
Calculated on	Principal only	Principal + accumulated interest
Growth over time	Linear	Exponential
Best for	Short-term loans	Long-term savings

How Does Compound Interest Work?

The best way to explain how compound interest works is to explain the compounding interest frequency concept. This concept refers to how often interest is calculated and added back to the principal balance of an account. Every time interest is compounded, the newly earned interest is added to your original deposit. Then moving forward, you earn interest on your original money in addition to the interest you’ve already made. This is the phenomenon of “interest on interest!”

The frequency of this compounding schedule has a massive impact on how fast your money grows. Interest can be compounded on a variety of schedules. The most common frequencies are:

• Annually: Once a year
• Semi-Annually: Two times a year
• Quarterly: Four times a year
• Monthly: 12 times a year
• Daily: 365 times a year
• Continuously: Every split second. Infinitely!

There is a “golden rule” for all of this: The more frequently interest compounds, the quicker your balance will grow, even if the starting interest rate is the same. If you want to dig deeper on this topic, the Federal Deposit Insurance Corporation is a great resource for additional information on compound interest.

Example of Compound Interest

Here’s a breakdown using a real-world example:

Let’s say you deposit $5,000 into a Certificate of Deposit account with a 4% APY that compounds monthly. If this were simple interest, you would earn a flat $196.00 every year. But because it’s compound interest, your money snowballs. Here is exactly how that looks at Year 5 and Year 10:

Five Years In: Basic Principles

For the first few years, the growth feels steady, but moderate. You’re earning interest on your initial $5,000, plus the small amounts of interest added each month.

• Starting Balance: $5,000
• Total Interest Earned (Years 1–5): $1,083.22 at 4% APY (This is calculated for year 0-5, as they are compounding starting from the first day of deposit.)
• Year 5 Ending Balance: $6,083.22 at 4% APY

Ten Years On: Accelerated Savings

This is where things get exciting! In the second five-year span, you aren’t just earning interest on your original $5,000, you’re now earning 4% interest on the $6,083.22 you built up in the initial five years. The real growth of your savings is tangible!

• Year 5 Balance: $6,083.22
• Total Interest Earned (Years 6–10): $1,317.90
• Year 10 Ending Balance: $7,401.12 using 4% APY as the rate

Comparing the Eras: The Acceleration Difference

Let’s look at the two 5-year periods side-by-side to see how the growth accelerated:

Time Period	Interest Earned	The Acceleration Bonus
First 5 Years (Years 1–5)	$1,083.22	Baseline growth
Second 5 Years (Years 6–10)	$1,317.90	+$234.68 extra

Why did this happen?

You didn’t add a cent of your own money after the first day. The extra $234.68 generated in the second half of the decade happened purely because your interest was out there making its own interest.

If you left that same money alone for 30 years, that final 5-year chunk would net you nearly $2,887.91 in interest alone. When it comes to compounding, time is the ultimate multiplier.

How Compound Interest Works in a Savings Account

Your savings account at Passumpsic Bank is already using compound interest. Your checking and CD accounts use it, too. The Annual Percentage Yield (APY) reflects compounding; that’s the number to pay attention to when you’re comparing savings accounts. High-yield savings, money market accounts and certificates of deposit (CDs) benefit most from compound interest. 

Why Compound Interest Matters for Your Financial Future

Starting earlier matters more than starting with more money when it comes to compound interest. If you give your money more time, the arrow will point upward! Even if you’re only able to make small, consistent deposits in a savings account, doing so over a long period of time will be of great benefit thanks to compounding interest.

Key Takeaways

Being able to answer the question, “what is compound interest?” and what it means for your savings can be a great benefit to you. Here are some key takeaways:

• Remember that compound interest earns interest on your principal AND your previously earned interest.
• The more frequently your interest compounds, the faster your savings will grow.
• APY (annual percentage yield) reflects compounding, so be sure to use it when comparing savings accounts.
• Time is the most powerful factor in compounding, so starting earlier makes a strong impact.
• Your Passumpsic Bank savings account, CD, or money market account is already working with compound interest. 

Ready to Put Compound Interest to Work?

If you don’t have an account with compound interest working for you, we’ve got some options so explore Passumpsic Bank’s savings options and see how your money can grow over time with the power of compounding! And if you’re ready now, you can open an account online with ease at your convenience or stop by any branch. Our local team in Vermont and New Hampshire is here to help!

Frequently Asked Questions

What is compound interest in simple terms?

Compound interest is interest earned on both your original deposit and the interest you’ve already accumulated. Unlike simple interest, which only calculates on your starting balance , compound interest grows on itself over time, causing your savings to accelerate the longer you leave them untouched.

How is compound interest different from simple interest?

Simple interest is calculated only on your principal balance, so you earn the same dollar amount in interest every year. Compound interest is calculated on your principal plus any interest already earned, meaning your balance grows faster over time. For long-term savings goals, compound interest makes a significant difference.

How often does interest compound in a savings account?

It depends on the account. Interest can compound daily, monthly, quarterly, or annually. The more frequently it compounds, the faster your balance grows, even if the stated interest rate is the same. When comparing savings accounts, look at the APY (Annual Percentage Yield), which already reflects the compounding frequency and gives you a true apples-to-apples comparison.

Does Passumpsic Bank use compound interest on savings accounts?

Yes. Passumpsic Bank savings accounts, checking accounts, and CDs all use compound interest. The APY listed for each account reflects compounding, so that’s the number to use when evaluating how your money will grow over time.

When should I start saving to benefit from compound interest?

The earlier the better. Time is the most powerful factor in compounding. The longer your money stays in an account, the more interest builds on itself. Even small, consistent deposits made early will outperform larger deposits made later, because the earlier money has more time to compound.