Compounding interest is the process of earning interest not only on the initial principal amount invested, but also on the accumulated interest over time. In other words, it is interest earned on interest.
When interest is compounded, the interest earned in one period is added to the principal amount, and the interest for the next period is calculated based on the new higher balance.
The growth of your savings will accelerate over time due to compounding interest on a balance that includes the interest already earned.
Compound Interest Example
With compound interest, even if you don't make any additional deposits, your earnings will accelerate.
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Graphic of interest-on-interest
Thanks to the magic of compound interest, your savings account balance expands as you earn interest on increasingly larger balances. And, this is why amazing savings accounts that pay high interest are so important. The higher the interest rate, the more money you earn.
Frequency of compounding
The frequency of compounding matters and determines how rapidly your balance grows. Interest is compounded—daily, monthly, or annually. Increasing the compounding frequency can help your savings grow even faster.
Savings accounts that compound daily will give you the most bang for your bucks. You might only see interest payments added to your account monthly, but calculations can still be done daily.
Here is an example of compounding frequencies and what it means to your bottom line using $100,000 as the initial deposit earning 5.00% APY:
What matters most to compounding interest
- The longer you leave money in a savings account, the longer it has to compound and the more you’ll earn. But interest rates matter most.
- Higher rates mean an account will grow more rapidly, especially over long periods.
Types of accounts that earn compounding interest
There are several types of bank accounts that earn interest. But here are the most popular interest-earning accounts banks, credit unions, and non-bank financial institutions typically offer.
A savings account is an investment instrument that allows you to earn interest on your money while keeping it safe from stock market fluctuations. Savings and money market accounts are subject to a federal law called Regulation D (“Reg D”) that limits the number of transfers and withdrawals to six each statement cycle.
Checking accounts are designed to conduct daily financial transactions and can be accessed using checks, electronic debits, ATMs, and wire transfers. Even though checking accounts are very liquid, some may also earn interest on deposits. High-interest checking accounts earn money similar to savings accounts but you are not subject to the six withdrawal limit each statement cycle under Regulation D.
Money market accounts.
Money market accounts are a type of investment instrument that have some features that are found in both checking and savings accounts. The best money market accounts pay a higher interest rate than regular savings accounts and may include check-writing and debit card privileges, giving you easy access to your money.
Certificates of Deposit (CDs).
A certificate of deposit (CD) is an investment instrument that earns high returns in exchange for the customer agreeing to leave a lump-sum deposit untouched for a predetermined period of time. CD terms can range from 3 months to 5 years.
401(k) accounts and investment accounts.
Earnings in your 401(k) and investment accounts also compound over time but the average rate of return depends on what your portfolio is invested in. Depending on the investments, you can expect to see returns of 3% or up to 10% according to retirement planners.
How to take advantage of compound interest
There are a few ways that consumers can take advantage of compound interest.
1. Save Early and Save Often
The magic of compound interest comes from time horizon. The longer you leave your money in a savings instrument, the more interest it can accrue. It’s never too late to start saving. However, there are several benefits to starting early.
- First, you’ll build up an emergency fund before you need it.
- Second, you’ll have a better chance of meeting your financial goals.
- Third, the more time your money stays in the account, the more compounding can occur.
Consider an example of someone who saves $2,500 a year for 40 years starting at age 25 compared to someone that saves the same yearly amount but starts at age 40. Assuming the savers earn 9 percent annual returns in a mutual fund, compounded daily, here’s how much they will have at age 65.
|By 65 years old
Both people earn the same interest rate, but the person who saved earlier winds up with far more by the age of 65. Compounding can help fulfill your long-term savings goals, especially if you have time to let it work its magic over years.
2. Compare APYs
An annual percentage yield, or APY, is the rate of return on money in a bank account or investment instrument taking into account the effect of compounding interest. The higher rate of return, the more interest you’ll earn on your money.
Comparing the APYs at different financial institutions is the first step in choosing where to you save your money. Online savings accounts will undoubtedly offer better rates than banks and credit unions with physical locations.
3. Check the frequency of compounding
We've already discussed the frequency of compounding interest. But when comparing savings and investment accounts, don’t just look at the APY. The more often interest is compounded, the better. An account with more frequent compounding can pay more interest over time.