Key Takeaways
- Compound interest creates a multiplying effect on your savings by paying interest on the principal balance and all accumulated interest.
- The more frequently interest is compounded, the faster your balance will grow.
- The annual percentage yield, or APY, reflects the interest rate and compounding frequency, offering a better comparison point when choosing a new savings account.
The interest rates on savings accounts continue to look veryappealing as the Federal Reserve keeps rates high. If you want to take advantage of the great rate environment, though, the interest rate isn’t the only thing that will maximize the cash in your account. As you compare savings options, you need to read the fine print to determine the account's compounding frequency, too.Â
Here's what you need to know about compound interest and what it means for your money.
What is compound interest?
Compound interest is interest that accumulates on interest. Rather than solely paying interest on your deposit -- as simple interest does -- compound interest pays on that principal balance and the interest it earns. Over time, the interest earned is added back into your principal balance, therefore increasing your principal. And as your principal grows, so does the amount of interest you earn on it, which grows your money further.Â
How does compound interest work?
How frequently your interest compounds determines how often interest is paid out. Daily compounding increases your balance the quickest, but some banks compound monthly, quarterly or annually.
There are plenty of handy calculators to figure out compound interest. But at the core of it all is this formula:
Final balance = Initial balance (1+ interest rate / number of compounding periods) ^ number of compoundings per period x number of periodsÂ
For example, if you deposit $10,000 into a savings account that earns 3% interest compounded annually, you’ll earn $300 per year. 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.
$10,000 (1 + 0.03/365) ^ 365×1 = $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.Â
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 it can vary depending on the bank.Â
The difference between compound interest and simple interest
Simple interest is different from compound interest because it’s calculated based on the principal, or original deposit. Earned interest isn’t incorporated or reinvested into the principal like it is with compound interest. Simple interest is used to calculate the interest charges on most mortgages, car loans and personal loans.Â
Let’s say you have two savings 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.Â
After 10 years, assuming the interest rate stays the same, you’d earn $64,070.09 in interest with the account that compounds. You'd only earn $50,000 in interest in the account that uses a simple interest calculation.
How to maximize your return with compound interest
The greatest benefit of compound interest is simple: You don’t have to do anything to grow your money. You get to sit back and watch the balance build up as long your money stays in the account. However, there are some simple steps to follow to make sure you’re setting yourself up for the best possible return.
Save early
The longer you leave your cash in a savings account or money market account, the more time it has to grow. If you have cash sitting in a checking account that isn’t earning interest, you should consider shifting that money to an interest-bearing account to take advantage of compound interest.Â
Open an account with a higher APY
The annual percentage yield, or APY, tells you how much interest you'll earn in a year based on the account's interest rate and compounding frequency. There are plenty of high-yield savings accounts, money market accounts and CDs that offer APYs of 5% or more right now. If your account APY is lower than that, moving your money to an account with a higher APY is an easy way to grow it faster.
Open an account with daily or monthly compoundingÂ
The more frequently interest compounds, the more interest you earn. An account that offers a slightly lower interest rate but compounds more frequently may be a better choice than an account with a slightly higher interest that compounds quarterly or annually.
Automate your savings
Compounding alone won't make you wealthy. To do your part, make sure you’re regularly contributing money to the account. If you automate your savings, it can make a big impact on your balance.
Keep an eye on your interest rate
And while you should set your savings on autopilot, you should periodically check in on the rate on your account. Rates on savings and money market accounts are variable, which means the bank can change them at any time. Compare your rate with the best savings rates available to make sure you’re getting the best deal possible.
Keep in mind that APY reflects the total amount of interest paid in a year and takes into account both the interest rate and compound frequency. So if you’re comparing two savings accounts and know the APY for both, you can compare the APYs directly without worrying about how the compound frequency will affect your interest earnings.
The bottom line
When it’s on your side, compound interest is a powerful financial phenomenon that can help build your wealth faster. 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. 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 boost to your earning potential.Â
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.
