Investing can be an effective way to use your money to make more money. And if you have a lump sum of money that you’re looking to grow, compound interest can play a key role in maximizing your rate of return, or the percentage change in the value of the investment. This is particularly relevant when depositing money into a savings account because how often your bank compounds interest will be a primary factor in how much interest you can earn.
What is compound interest?
When you deposit money into a savings account, the bank pays you interest. Over time, the interest you earn increases your principal or the amount you’re earning interest on. And as your principal grows, so does the amount of interest you earn on it, creating a flywheel that can grow your money further. How frequently your interest compounds is a key factor here; daily compounding will increase your balance the quickest, but some banks compound on a monthly, quarterly or annual basis.
How does compound interest work?
To calculate compound interest, use the following formula:
Initial balance (1+ interest rate / number of compounding periods) ^ number of compoundings per period x number of periods
For example, if you deposit $10,000 into a savings account that earns 3% interest compounding annually, you’ll earn $300 which, added to the principal amount, you would have $10,300 at the end of the first year.
$10,000 (1 + 0.03/1) ^ 1×1 = $10,300
If you deposit $10,000 into a savings account that earns 3% interest -- but compounds daily -- you’ll earn $10,304.53. That daily compounding earns you an additional $4.53. That doesn’t sound like much, but with larger amounts and over longer terms, the rate of return of compound interest can be significant.
$10,000 (1 + 0.03/365) ^ 365×1 = $10,304.53
Note that a high-yield savings account or money market account may offer interest that compounds daily, weekly or monthly. Certificates of deposit typically compound daily or monthly but can vary.
The difference between compound interest and simple interest
Interest is calculated in one of two ways, depending on whether it’s compound interest or simple interest. Simple interest is calculated on the principal or original deposit, and doesn’t incorporate interest that’s been subsequently earned. With mortgages, personal loans and car loans, interest is usually calculated in simple terms.
If, for example, you take out a loan for a new car for $25,000 and your interest rate is 4% for a period of 60 months (five years), your estimated monthly payment will be $460.
How to maximize your return with compound interest
Save early
The longer you leave your investment in a savings account or money market account, the more time you have to leverage the power of compounding. If you typically have a balance sitting in your checking account that isn’t earning interest, it’s worth considering shifting that money to a savings account, or other investment vehicle, to take advantage of compound interest.
Open an account with a high APY
A high annual percentage rate is not ideal when you’re the one borrowing. A high interest rate for a revolving line of credit like a credit card will cost you over time, as your balance grows due to compounding interest. When the bank is borrowing from you, however, like with a savings account, the higher the annual percentage yield, the more interest you’ll earn. Check out CNET’s list of the best high-yield savings accounts.
Open an account with daily or monthly compounding
When considering different savings accounts, how frequently interest compounds should be a major factor. The more often interest compounds, the more interest you earn. An account that offers a slightly lower APR but compounds more frequently may be a better choice than another account with a slightly higher APR that compounds quarterly or annually.
The bottom line
Compound interest can be a great way to increase your savings over time. When you’re comparing savings accounts, look at the interest rate and the compounding period to get the best return on your money.
Correction, 1:55 p.m. PT Jan. 16: An earlier version of this article suggested a saver would earn $10,300 after a year by depositing $10,000 into a savings account that earns 3% interest compounding annually. The article has been corrected to clarify that the saver would earn $300 on top of their $10,000 principal amount. A similar correction was made to the subsequent example, where the article was corrected to clarify that the saver would earn $304.53 on top of their $10,000 principal amount. The earlier version also incorrectly stated that one-year CDs only compound annually. The earlier version also incorrectly stated how much a consumer would pay monthly on a car loan with an interest rate of 4% over five years. The earlier version also incorrectly stated that a savings account with a slightly lower APR, but compounds more frequently, may be a better choice than an account with a slightly higher APY that compounds less frequently. In that example, APY has been corrected to APR.
