Compound interest is what happens when the interest you earn starts earning interest of its own. It's the single most powerful force in personal finance — not because the math is complicated, but because time does most of the work for you.
How it's calculated
Each month, your balance grows by the interest rate divided by 12, and then your monthly contribution is added on top. Next month, interest is calculated again — but now on a slightly bigger balance, because last month's interest is now part of the principal. Repeat that every month for years, and the growth curve stops looking like a straight line and starts curving upward.
A worked example
Say you start with $5,000, add $200 every month, and earn 7% a year for 20 years. You'll have contributed $53,000 of your own money in total — but your final balance will be well over $100,000. The gap between those two numbers is entirely interest earned on interest, and it grows faster the longer you leave the money alone.
Common mistakes
The most common mistake is underestimating how much of the growth happens in the later years — compounding is slow at first and dramatic later, so people often give up too early. The second is assuming a rate of return that's unrealistically high; a long-term average around 6–8% for a diversified stock portfolio is a reasonable planning assumption, not a guarantee.