🌱 BeginnersWhat is compound interest and how does it work?
Compound interest is the return you earn not only on what you put in at the start, but also on the return that has already been added. Your gain starts generating its own gain. It sounds small, but over many years it creates a snowball effect: your capital grows faster and faster. The difference from simple interest, where you earn the same amount each year on the principal only, gets bigger every year. In this article you will see the formula, a worked example in euro, and the rule of 72.
The formula
The basic formula is: final amount = deposit × (1 + rate) to the power of the number of years. The rate is entered as a decimal, so 5% becomes 0.05. The number of years sits in the exponent, and it is the exponent that produces the acceleration.
The more often the return is added to the capital (monthly rather than annually), the stronger the effect, because your return starts compounding sooner. This is called compounding: the return is added to the whole sum, which then grows further.
A worked example in euro
Say you put €10,000 into a broad fund that returns 6% a year on average and leave the money for 30 years without adding or withdrawing anything. With simple interest you would get 30 × €600 = €18,000, a total of €28,000. With compound interest it becomes roughly €10,000 × 1.06 to the power of 30, which is around €57,400 — nearly €30,000 more, purely from return on return.
If you also add a fixed amount every month, the effect is stronger still, because each new contribution starts compounding from that point. That is why starting early and keeping going usually matters more than the size of your first deposit.
Time and the rule of 72
The rule of 72 is a quick way to estimate how long it takes for a sum to double: divide 72 by the annual return as a percentage. At 6% a doubling takes about 72 ÷ 6 = 12 years. At 3% it takes 24 years.
The same maths works against you in debt where interest compounds, such as an unpaid credit card balance. There, compound interest makes the debt grow faster and faster if you only pay the minimum.
Frequently Asked Questions
- What return should I assume?
- Use a cautious figure after tax and charges. For a broad, low-cost equity fund, 5-7% a year over the long term is often cited as historically reasonable, but returns are not guaranteed and vary a lot from year to year.
- How often does compound interest get added?
- On a savings account, usually once or twice a year. In funds it happens continuously through price changes and reinvested dividends. The more often the return compounds, the bigger the effect.
- Does compound interest work with small amounts?
- Yes. The effect depends on the return and the time, not on the size of the amount. A small monthly contribution given many years can grow into a significant sum.
Informational content, not financial, tax or legal advice. Check amounts, limits and current rules directly with the official sources (the Department of Social Protection, the Central Bank of Ireland, Revenue, the Deposit Guarantee Scheme) before making a decision.
