The (almost) magic of compounding

E*TRADE from Morgan Stanley


Compound interest has been called one of man's greatest inventions, but we'll settle for calling it a saver's best friend. Here's why.

What is compounding?

Essentially, compounding means that you earn new returns on the gains you've previously made. Here is a hypothetical example just to illustrate the math, rather than a particular type of account or investment:

Year 1

Principal investment $1,000

Year 1 interest

Year-end balance

Let's say you deposit $1,000 in an account (that's your principal). If the account earns 10% interest, you've earned $100 after a year.

So far, so good. Now watch what happens in year #2.

Year 2


$1,100 year-end balance

interest on
year 1 interest

Year 2 interest

Year-end balance

You've earned more in year two ($110) without depositing any more money from your pocket! It's not magic, it's just wonderful math. Not sure why it's so great? Take a look at what happens if we let it ride for 20 years.

Year 1

$1,000 principal + $100 interest

graph $1,000 principal plus $100 interest

Year 20

$1,000 principal + $5,272 interest

Year 20 - $1,000 principal + $5,272 interest

We showed you the result after 20 years for a good reason: the key to compound interest is time. Check out the difference between compounding for 10 years versus 30 years.

Total after 10 years


10 year small dot

Total after 30 years


30 year big dot

One more big point: compounding can happen in savings accounts or potentially in investment accounts, but there is a difference. The interest rate on a savings account is typically guaranteed for a certain period, and in the last ten years has hovered in the low-single digits on average.d1

Compound returns can occur in an investment account, but with more risk and volatility than in a savings account, including the potential loss of principal. Of course, with higher risk comes the possibility of higher reward.

How to make compounding work for you

Start early - lady

Start early

We can't say this enough. Compounding is fantastic, but it needs time to work.

Stay invested - piggy bank

Stay invested

If you withdraw your profits and put them in your pocket, your earnings don't compound. So keep your gains invested and re-invest payments you might receive such as interest on savings and bonds, or dividends from stocks.

Another thing we'd like to point out about our example above is that we did not include any fees or taxes that may apply in a real account, because we wanted to demonstrate the pure mathematical concept of compounding. Most accounts would have some kind of fees that would impact the rate of return, and we all know the old saying about death and taxes. We are also not making any kind of prediction or projection about performance or any particular strategy.

How can E*TRADE from Morgan Stanley help?

Brokerage account

Investing and trading account

Buy and sell stocks, ETFs, mutual funds, options, bonds, and more.

Premium Savings Account

Boost your savings with 4.25% APY1

With rates 9X the national average2, plus FDIC protection up to $500,0003, and more.

What to read next...

Asset allocation is how you choose to divvy up various assets within your portfolio, like stocks, bonds, and cash. Here’s a breakdown of how it works.

Here are four key guidelines to help you prioritize your saving and balance your long- and short-term financial goals. 1) Create a budget. 2) Build an emergency fund, then prioritize long-term goals. 3) Save separately for short-term goals. 4) Boost your saving and be disciplined about spending.

Because saving and investing are in some ways similar, many of the same ideas apply to both, including the risk of losing money, how easy it is to access your funds, and potential gains. But there are significant differences in exactly how those ideas apply and in how you actually go about saving versus investing. Let's break down the details.

Looking to expand your financial knowledge?