EyeOnThe short answer
Yes. When interest is added to a balance and later interest is calculated on that larger balance, earlier interest generates more interest. Whether this happens on a particular debt depends on the agreement.
What it means
With simple interest, interest is only calculated on the original amount. With compound interest, each period's interest is added to the balance and the next period's interest is calculated on the larger figure.
It works in both directions. On savings and investments it can help balances grow. On debts that are left unpaid it can make the amount owed grow.
How it works
How often interest is added (daily, monthly, yearly) affects the result. More frequent compounding gives a slightly higher effective yearly figure at the same stated rate. The time you leave the money matters even more, because each period builds on the last.
Regular additions or repayments change the picture, as each one alters the balance on which later interest is calculated.
A simple example
Put 1,000 aside at 5% a year and add nothing. After 10 years, simple interest would give 1,500. With yearly compounding it would be 1,000 x 1.05 to the power of 10, which is about 1,628.89. The extra 128.89 is interest earned on interest. Rates are not guaranteed and this is only an illustration.
Things worth checking
- Check how often interest is added and whether the quoted rate is nominal or an effective yearly figure.
- On debt, small balances left alone can still grow, which is why the cost of carrying a balance matters.
- Real-world returns on investments vary and can be negative, unlike a fixed illustration.
- Fees and tax can reduce the effective growth.
How it varies by country
Compounding conventions and the way rates are quoted differ between countries and products, so read the account or agreement terms for the exact method.