Compound interest is a financial term used to describe the process where the interest earned on a principal investment over a set period of time is added to the principal amount. The interest payable for the following periods is recalculated on the sum of the original investment and the previous interest earned. The word "compound" refers to the magnified effect that this method has on an investment's growth potential.
Compound interest yields higher returns on an investment over a protracted period of time than the returns available on simple interest investments. For example, 3 percent simple interest calculated on a $20,000 investment earns $3,000 over a period of five years. If the same investment receives compound interest, the terms yield a $3,185.48 return after five years.
The periods used to calculate compound interest vary and are determined according to the terms of each individual investment. The more frequent the periods are, the faster an investment grows. For example, 7 percent interest applied to a $50,000 investment earns $36,699.30 in interest over the course of eight years if compounded twice annually. If the same investment is compounded monthly, it earns $37,391.32 after eight years. Compound interest is an excellent way to build an investment, but Investopedia notes that it can be equally as harmful if applied to borrowing terms.