An investment, be it in a savings account or a CD, can get a hefty boost with the help of compounding interest, whereby your earned interest earns interest. Compound interest isn’t rocket science, but this remarkably effective financial concept can get the attention of even the sharpest of sharp-minded scientists. Legendary physicist Albert Einstein referred to compounding interest as the eighth wonder of the world, adding that “those who understand it, earn it and those who don’t, will pay it.”
Compound interest is integral in maximizing your rate of return, especially when depositing money into any type of savings account. How often your bank compounds interest is a major factor in how much interest you can earn. But compound interest can work against you if you’re repaying a loan or line of credit with interest that compounds.
Read on to understand more about compound interest and how it can boost your savings.
What is compound interest?
When you deposit money into a savings account, your bank typically pays you interest just for keeping your money in the bank. Over time, the interest earned is added back into your principal balance, therefore increasing your principal. And, as your principal grows, so too does the amount of interest you earn on it, creating a flywheel effect 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 see how the power of compounding works, let’s turn to American history. Famed founding father (and penny-saving proponent) Benjamin Franklin, stipulated in his will that two cities, Philadelphia and Boston, be gifted $2,000 each. The gifts were to be invested using compound interest with two payouts, one in 100 years and the other, 200 years after his death. In 1991, the remaining account balances totaled $6.5 million.
To figure out compound interest, there are plenty of handy calculators, but at the core of it all is this 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. Adding that to the principal amount, you’ll have $10,300 at the end of the first 12 months.
$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 wind up with $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 but doesn’t incorporate interest that’s been subsequently earned.
Let’s say you have two accounts and you deposit $100,000 in each account. They both earn an annual interest rate of 5%, however, one account uses simple interest to calculate your return, and the other compounds your interest monthly.
After 10 years, assuming the APY remained consistent, you’d earn $64,701 in interest with the account that compounds. The account that uses a simple interest calculation would earn you only $50,000 in interest.
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’ll have for it to grow. If you have cash sitting in your checking account that isn’t earning interest, you should consider shifting that money to a savings account, or other interest-bearing investment vehicle, to take advantage of compound interest.
Open an account with a higher APY
A high annual percentage rate isn’t 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 as a result of compounding interest. However, when the bank borrows from you, like in 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 is 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 is a powerful financial phenomenon that can help build your wealth faster and increase your retirement potential. You can take advantage of the power of compound interest by selecting accounts that compound more frequently -- daily or monthly -- and earn the highest APY available. There’s no need to be a rocket scientist to appreciate how compound interest works on your savings. Understanding a few basics, such as the account’s compounding period, and comparing APYs can help you better implement a savings strategy that’ll provide a greater boost to your earning potential.
Correction: An earlier version of this article was assisted by an AI engine and it mischaracterized some aspects of CDs, savings accounts and loan payments. Those points were all corrected. This version has been substantially updated by a staff writer.
