Compound interest is interest calculated on the principal amount invested, which is then added to the principal amount, and compounded again. Compound interest can be earned daily, weekly, monthly or yearly. Generally the more times an amount is compounded, the more money you can make.

As long as you leave an interest earning account alone, by not removing money from it, you begin making more money on your investment (given a stable interest rate) because the money you earn is added back to the principle amount. It’s a simple fact that more money earning interest makes you more money. Each time interest is compounded, the money earned gets added to the total.

If you were raising two rabbits, you might view a similar thing. If the bunnies produced a litter, and you kept all those bunnies, then you might have possibly eight rabbits. The original bunnies would keep on breeding, as would the new litter, and you’d end up with more rabbits then you knew what to do with. Compound interest won’t be quite that dramatic, unless you’re investing huge sums of money. The important parallel is that the first pair of bunnies (your original investment) and their offspring (interest) now combine together to produce yet more bunnies, and as combined, they will produce a great deal more than if they were sold off and separated.

Most investment firms, banks, and the like, will state how often your interest is compounded. In some cases, your investment doesn’t compound, but earns what is called simple interest. This means you only make money on the amount you initially invested, and the profits are not reinvested to make you more money.

You can figure out exactly how much an investment will be worth in a few years if you have a scientific calculator handy. You also need to know the initial investment amount (principal or p), the rate of interest, (r), the number of years you plan to allow the investment to sit (years or y) and the number of times per year you investment will compound (t). Recall that only a portion of the interest would be earned each month, so the interest amount would have to be divided by the total times interest gets compounded each year (t). The formula is as follows:

Total value = p(1 + r/t)^ty

Putting this to work, in dollar amounts, you might invest $10,000 US Dollars (USD) in a savings account that earns 5% interest per year and is compounded monthly. If you leave that money alone for five years, you could figure out exactly how much money you’d make in that time period, and the value of your account at the end of four years. The equation would look like this:

10,000(1 + .05/12)^{12 X 5} = $12,833.59

If you only earned simple interest, at even 5.5% per year, you wouldn’t make that much money. Note the following:

10,000(1 + .055 X 5) = $12,750.00

One reason to understand compound interest is because some accounts that earn simple interest offer a higher yearly interest rate. Yet if your investment is long term, you may make more money with a lower interest rate that compounds your interest. On the other hand, if you know you’ll be removing the money after a year or two, a higher interest rate that is not compounded may be a better investment, than an account with compound interest at a lower rate. Also, don’t be daunted by these formulas if you are calculating interest. If you have access to the Internet, you can find hundreds of sites that offer compound interest calculators and most of them are very easy to use.