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What is Compound Interest on a Savings Account?
Key takeaways
- Compound interest earns returns on both your principal and accumulated interest, making your savings grow faster than simple interest over time
- APY (annual percentage yield) reflects compound interest's true impact on earnings, so if offers a convenient way to compare interest-bearing accounts
- To fully harness compound interest's power for long-term financial security, start saving early and contribute regularly while avoiding withdrawals
Compound interest is interest that is calculated on both the principal (the amount you deposit) and the interest that has been added in previous periods.
Compound interest, which pays interest on the interest, can grow your money over time more powerfully than simple interest.
The power of compound interest is that it puts more money in your pocket. When you understand how it works, you can take advantage of it in your personal finances.
In this article we'll explore the question "What is compound interest on a savings account?" and explain how this type of interest can promote long-term savings growth.
How does compound interest work?
If a savings account offers a simple interest return of 2%, your savings will grow by 2% in a year. A deposit of $1,000 becomes $1,020 ($1000 x 0.02 = $20).
If that account used compound interest, the return would be greater because every so often—perhaps every day, month, quarter, or year—the interest would be calculated and added to the account. Then, the next time the interest is calculated, it is factored against a larger amount than just the principal. Every time your money earns interest, the bank will pay you interest on the previous interest that's been earned.
Let's gain a better understanding of compound interest by looking at an example.
An example of compound interest
Imagine you deposit $10,000 into a savings account earning 4% APY, compounded daily.
After one year, you would have $10,400 with simple interest and $10,408.08 with compound interest. The difference isn't big, but the compounding effect becomes more powerful over longer periods. After 10 years, that same $10,000 would grow to $14,917.92 with compound interest, but only $14,000 with simple interest—and that's without deposit additional funds.
You can see for yourself how to grow savings faster by using a compound interest calculator, such as this one offered by the U.S. Securities and Exchange Commission.
Why is compound interest important for savings?
Because of its advantages, it makes sense to find a savings account that provides compound interest and has the highest interest rate—if there are no fees or other factors that might subtract from your savings. This is because:
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Your savings grow faster. As we've seen, compounding results in a larger savings balance
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It rewards consistent saving. Automatic transfers to savings or regular monthly deposits can maximize compound interest and provide long-term savings growth
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It builds long-term financial security. Emergency fund savings accounts, certificates of deposit, and college savings all can help you reach your savings goals by providing compound interest
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It combats the impact of inflation. Compound interest can increase your savings to potentially outpace the rate of inflation in the larger economy
How does APY relate to compound interest?
When you are comparing savings accounts, you are likely to see banks promoting their APYs (annual percentage yields) rather than their interest rates.
That's because the APY reflects your rate of return when compound interest is considered. It is slightly different from a straight interest rate and gives a more complete indication of your earnings potential with that account.
How do I maximize compound interest on my savings?
You can take advantage of the benefits of compound interest by following a few simple tips:
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Choose a high-yield savings account. A high-yield savings account vs. a traditional savings account will grow your money even faster. Read the terms and conditions to make sure you meet any requirements, such as a minimum balance
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Compare compounding frequency. Interest can be compounded daily, monthly, quarterly, or annually. Daily compounding typically provides the best APY, but the difference might not be enough to make it a deciding factor
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Start saving as early as possible. It's never too early to set up a savings account for a child or grandchild
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Avoid unnecessary withdrawals. Think of these savings as your secret weapon, protecting you from financial emergencies and ensuring long-term financial security
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Contribute regularly. Regular deposits made directly from your paycheck can help you grow savings faster, as will any other automatic transfers to savings
FAQs
It depends on the bank and the type of savings account. Typical frequencies are daily, monthly, quarterly, and annually.
For example, with monthly compounding, a bank calculates and adds interest to your account balance twelve times a year. With daily compounding, the bank calculates the interest on the balance and previous interest daily. However, banks generally track those daily calculations but add the accrued interest to your account monthly. Daily compound interest carries an advantage, but it's not so large that it should be the only thing you consider when selecting a savings account.
APY stands for annual percentage yield, the true yearly return on an interest-bearing account. It includes the effects of compounding. The APY can vary depending on interest rates in the wider economy.
Over the long term, compounding can provide significantly better results than simple interest. It mitigates the effects of inflation and can provide a better return on your money. The advantage can be reinforced by making regular contributions to an account while minimizing withdrawals.
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