Definition of Compound Interest

What is "compound interest"? What is the definition of the term "compound interest"?

Let's say that you are investing for your retirement. You started with $1,000 and will invest $1,000 every year. For simplicity sake, let's say that the interest on your investment will be 10% per year.

Definition of Compound Interest - Financial DictionaryIn your first year, you make 10% on your initial investment of $1,000. After your interest is calculated, you end Year 1 with $1,100 ($1,000 in principal, $100 in interest accumulated).

In Year 2, you also achieve a 10% return on your investment. However, the amount of interest accumulated in Year 2 is substantially higher than in Year 1 because the interest is being calculated on $2100 ($1,000 initial investment, $100 interest from Year 1, $1,000 investment at the beginning of Year 2).

So, in Year 2 of your investing program, you would receive $210 in interest income ($2,100 * .10), up from $100 in Year 1. Assuming you managed to maintain a 10% return on your investment, you would make a progressively larger amount of interest every year.

This is "compound interest".

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