Table of Contents
Table of Contents
Whether you're planning for college costs, a down payment or an upcoming vacation, regularly saving part of your income helps make achieving your financial goals possible. The earlier you start, the easier it becomes to build the assets you need. Determining where to put your money is also important.
When you contribute to a compound interest account, the return on your savings starts to accelerate over time. The longer you leave your money in these accounts, the greater the effect. Here's a look at how compound interest works and how you can take advantage of this powerful feature.
What Is a Compound Interest Account & How Does It Work?
Compound interest is a way of computing the amount of interest a bank or credit union pays on certain accounts. It's one that works to the advantage of depositors. If you open an account that offers compound interest, the bank will make its first interest payment based on the amount of your original balance, also known as the principal. The next time it pays interest, it adds the previous interest payment to your principal to calculate your new interest payment.
Because previous earnings continue being added to your principal when determining how much interest you receive, your new interest payments will keep getting bigger over time (assuming no withdrawals from the account). The impact may be minor in the first few months after making a deposit. But as years go by, it creates a snowball effect that grows continually bigger (again, disregarding withdrawals).
Compound interest differs from the simple interest method, in which your interest payment is always a percentage of your original principal. Therefore, the interest you're paid remains constant (provided the principal remains is left intact).
Fortunately, the majority of interest-bearing bank and credit union products use the compound interest method, whether for a savings account, a checking account or a certificate of deposit (CD). But before opening an account, it doesn't hurt to confirm what interest crediting method will be used and, if applicable, how often it is calculated (daily, monthly, annually, etc.).
Example of Compound Interest
Let's suppose that you deposit $1,000 into a savings account that pays a 3% annual interest rate. Assume that this bank compounds your returns on a daily basis, meaning they divide the annual rate by 365 and add that amount to your principal before making your next interest payment.
On the second day of owning the account, your account accrues $0.082 of interest (though it's typically only credited to your balance once a month). Because the interest is added to your principal each time, that payment increases ever so slightly every day. By the end of the first year, the bank will have paid you $30.45 in interest.
So far, that's not wildly different than if the account had paid simple interest, in which case you'd accrue $30 in interest after the first year. But over a significant period of time, the difference becomes much more significant.
Assuming there are no additional deposits or withdrawals, the account with compound interest would have paid you $822.07 in interest at the end of year 20. Even at a modest 3% interest rate, you nearly doubled your money. Compare that with a simple interest account that continues to pay $30 every year. At the end of year 20, it would have paid you only $600 in interest.
Factors That Impact Compound Interest Payments
The effect of compounding on your deposit depends on certain variables. Understanding how these factors impact your return can help you save more effectively — and choose the most advantageous account.
Account Balance
The interest you're paid is proportionate to your daily balance. So the more money you have in your account, the more interest you receive. And when compounding comes into play, that difference only gets bigger over time.
Interest Rate
A higher interest rate on your account means a higher rate of return. But the effect is even more pronounced with a compound interest account that adds each previous payment to your new interest calculation. If you make a single $1,000 deposit into an account that pays 1% daily compound interest, your balance will grow to $1,105 after 10 years. But that same deposit into an account paying 4% daily compound interest would be worth roughly $1,492.
Compounding Frequency
A bank or credit union account may compound your interest daily, monthly or annually. If all other factors are equal — including the interest rate — accounts that compound more frequently will deliver slightly higher returns over the long term. They're adding interest to your principal more often, which means the snowball effect is more pronounced. As the previous example showed, a $1,000 deposit into an account that offers 4% interest will grow to $1,492 after 10 years if the bank compounds daily. If it only compounds once a year, however, your eventual balance is only $1,480.
Account Fees
The interest rate and interest calculation method aren't the only criteria you should use when choosing a bank. The account fees charged should also factor into your decision, since these counteract the effect on any interest you're receiving. For example, a bank that pays a slightly higher interest rate than the competition may not be your best bet if it also charges an account maintenance fee. Keep in mind that most bank fees are a fixed dollar amount, so they take on less importance if you carry a higher balance. Before opening an account, a simple calculation comparing potential interest returns to potential costs can help make it easier to decide which institution to choose.
The Different Types of Compound Interest Accounts
The majority of FDIC-insured bank accounts pay compound interest. But even certain investments that don't distribute interest can provide compound returns if you manage your earnings strategically.
High-Yield Savings Account
The term "high-yield savings account" generally refers to accounts offered by online-only banks. Often, the annual percentage yield, or APY, for online accounts is several times higher than that of brick-and-mortar institutions, which can increase your long-term return. Like traditional savings products, most high-yield accounts compound interest daily and pay it monthly. However, there are exceptions so make sure to do your research and talk to a financial professional for more information.
Money Market Accounts
Money market accounts offer a similar rate of return to high-yield savings accounts. However, many of them also provide a debit card and allow you to write checks. Therefore, they may represent a "best of both worlds" offering for those who seek a competitive yield and the convenience of a checking account. Most money market accounts, like other bank accounts, are FDIC-insured up to allowed limits, and compound interest on a daily basis.
Certificates of Deposit (CDs)
A certificate of deposit, or CD, is a time deposit account, typically insured by the FDIC, where you forgo the right to make penalty-free withdrawals for a specific length of time, or "term." In exchange, the bank pays you a higher interest rate than you would receive with a traditional savings account. The longer the duration of your CD, expect the higher the APY you'll receive. As with most depository accounts, CDs generally pay daily compound interest.
If you withdraw your money before the CD matures, however, you may lose a certain amount of interest. Often, the penalty is dependent on the certificate's term. For example, a bank may charge you one month's interest (usually calculated using the simple interest method) if your CD term is less than 90 days or three months worth of interest if your term is six to 12 months.
Bonds
Bonds aren't bank products, but rather tradable securities where the issuer — generally a corporation or government — agrees to pay you the face value of the bond at the maturity date. Most bonds also come with a promise that the issuer will pay you interest at specific dates. The annual rate of interest that bonds accrue is known as the coupon rate, although the amount is typically split up into two semiannual payments.
Unlike most depository accounts, bonds pay simple interest rather than compound interest. However, you can still benefit from compound growth if you continually reinvest your earnings. Say, for example, that you buy a $10,000 bond that offers a 5% coupon that pays interest twice a year. When you receive $250 every six months, and use that money to buy a new bond or deposit it into a savings account, those initial earnings are generating additional earnings — just like a compound interest account. Bonds may experience reduced liquidity during certain market events, lose their value as interest rates rise and are subject to credit risk which is when the issuer is not able to make interest payments. When interest rates rise, the price of bonds generally falls.
Mutual Funds
Mutual funds pool money from investors and invest in stocks or bonds. They are managed by an investment firm. Because bond funds own many individual bonds, they don't have to wait six months to pay you interest — most make distributions to you every month. However, the fund may allow you to instead use those interest payments to buy additional fund shares. By using your interest to obtain additional earnings, this strategy enables you to achieve compound returns.
Even though mutual funds that own stocks don't generate interest, you can benefit from compound growth here as well. Most funds make periodic distributions of dividend income they receive (if any), as well as any capital gains they realize (again, if any) from the sale of shares. If you elect to reinvest those earnings, rather than pocketing the distribution, you're potentially generating a snowball effect that can boost your future returns. Keep in mind that mutual funds are subject to market risk. You could lose some or all of the principal amount invested.
Dividend Stocks
Stocks provide an investment return if the price of the stock goes up, allowing shareholders to sell their shares for a profit. Some companies also return some of the profit they generate to shareholders in the form of dividends. These tend to be established companies with a stronger cash flow. You can also get compound returns from your dividends if you use them to buy more shares.
How to Choose the Right Compound Interest Account
It's important to look at multiple features of a bank account before deciding which one is right for you. If you're looking for competitive interest rates and the ability to write checks, a money market account might be a good fit. But they do have certain drawbacks. For instance, they often require higher initial deposits than other products and may limit you to a few withdrawals per month. If those features aren't a fit for you, a high-yield (online) savings account, which typically does not have restrictions on how many transactions you can perform, may be a better fit.
If you know you won't need to touch your savings for a specific period of time, compound interest-paying CDs might be the way to go. These deposit accounts generally offer some of the highest rates of any FDIC-insured bank product, thereby providing greater growth potential while minimizing risk.
Where to Open a Compound Interest Account
The interest rate that a bank or bond issuer offers is a critical element when it comes to building wealth. Generally, online banks are able to offer higher returns on savings accounts than traditional ones. That can make a big impact if you're putting away a large amount of cash or plan to keep your money in place for a long period of time.
However, the rate of interest isn't the sole criteria to consider. You also may also want to weigh other important factors, such as:
- Whether the account is FDIC-insured (or NCUA-insured, if depositing at a credit union)
- How often the bank or credit union compounds your interest
- What maintenance fees and other charges you may have to pay
- How convenient managing the account would be (i.e. quality of mobile app, ability to bundle multiple accounts at one institution)
Various websites provide up-to-date comparisons of the interest rate at different national banks. But for more information about fees and other account features, you may have to explore the bank's website directly.
