What is compound interest?

People who have even a passing knowledge of the way their finances work generally know what interest is, but one aspect of this they may hear often is "compound interest."

Interest - like with a savings account - is simply the amount of money the funds already in the account earns over time, usually measured annually. So an interest rate of 5 percent means that for every dollar in the account, 5 cents will be added to that total over the course of a year. But often, that only refers to the amount in the account itself, not the interest it has already accrued. So if you wait a year without touching the money, that amount will be $21, but would only increase to $22 the next year.

Compound interest, though, takes into account interest earned as well. So without touching that $21, a compound interest rate of 5 percent would actually add $1.05 to that total for the next year.